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How will this wild GameStop saga end? The ghosts of trading catastrophes past offer clues

Champions of GameStop’s jaw-dropping stock surge portray it as a victory by long-suffering mom-and-pop investors over nefarious Wall Street institutions, but some veteran market observers see parallels with past trading catastrophes that ultimately left those same individuals holding the bag.

Richard Smith, executive director of the Foundation for the Study of Cycles, compared the run-up in shares of GameStop, along with other heavily shorted shares targeted by an army of individual investors via forums like Reddit’s WallStreetBets, to past market bubbles, albeit one that has materialized rapidly.

At some point, the pool of buyers will be exhausted, he and other market observers have warned, leaving the prices of shares that have soared purely due to trading flows to potentially collapse.

Opinion: Stop laughing about GameStop’s stock mania — no, really

The obvious parallel is the dot-com bubble of the late 1990s. Like that episode, “too many businesses are making too much money off of facilitating and encouraging speculative excess by the public,” Smith said in a phone interview. “I don’t think that it’s going to end well and I’m afraid that a whole generation of investors is at risk of being lost to the capital markets.”

In this case, the businesses encouraging speculative excess are online brokers and market makers, who have gamified trading and liquidity, effectively bringing Silicon Valley’s model of turning the “user into the product,” he said.

GameStop Corp. GME, +134.84% shares soared just shy of $200, or 135%, on Wednesday to end at $347.51. Shares have more than quintupled so far this week. They ended last year at $18.84. Shares of other heavily shorted companies, including theater chain AMC Entertainment Holdings Inc. AMC, +301.21%, also soared Wednesday, as Reddit users encouraged an effort to create additional short squeezes.

Read: It isn’t just GameStop: Here are some of the other heavily shorted stocks shooting higher

There’s nothing new about a short squeeze, when professional investors attempt to force short sellers to buy back shares to cover losses, accelerating gains and creating a feedback loop. What’s unique this time is the way individual investors have banded together via Reddit and other forums to do battle with short sellers.

The surge has been fueled by individual investors, many of whom bought out-of-the-money call options as part of a concerted effort to drive up the stock price. Market makers who sell the calls to individual investors must buy underlying shares to hedge their exposure. The sharp rally caught short sellers wrong-footed, forcing them to buy back shares at a loss, appearing to further accelerate the rally.

See: How an options-trading frenzy is lifting stocks and stirring fears of a market bubble

One such short seller, Melvin Capital, was effectively KO’d earlier this week, requiring an infusion of nearly $3 billion from hedge funds Citadel and Point72 Capital. On Wednesday, Melvin Capital’s Gabe Plotkin told CNBC that the firm’s short position was closed out the previous afternoon following a huge loss.

Also, Andrew Left of short seller Citron Research, in a video posted to YouTube on Wednesday, said he covered the majority of Citron’s short position in GameStop in the $90 price range.

The GameStop phenomenon, and its reliance on options-related activity by individual investors, can also be viewed as the latest chapter in a story that’s seen derivatives and supposedly sophisticated financial strategies wreak havoc in markets.

In a Twitter thread, quantitative finance pioneer Emanuel Derman laid out that history, beginning with the spread of portfolio “insurance” in the 1980s, developed by finance professionals using the Black-Scholes options-pricing model. That dynamic portfolio “hedging” was blamed for amplifying the October 1987 stock-market crash.

In the 2000s, credit default swaps made it easy for less-sophisticated segments of the finance profession to trade credit, contributing to the financial crisis, he said. More recently, options and futures based on the Cboe Volatility Index, or VIX VIX, -12.04%, “and the notion of volatility targeting for protection, made it easy for relative amateurs to trade volatility too, formerly also a professional skill,” he said.

Investors who had aggressively bet on a long stretch of market calm continuing got a rude comeuppance in February 2018, when the VIX spiked, forcing the unwind of short bets on volatility and blowing up some popular trading vehicles.

“It’s all part of the trend of using derivatives that make it apparently easy to do difficult things, which, when a few people do them, isn’t too bad, but which fail when everyone does them,” Derman wrote.

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