What is a Short Squeeze? Understanding the Reddit Speculators and GameStop Saga.

Before last week, you may have been thinking that a “short squeeze” was what Taylor Swift sued that creepy radio DJ over a couple of years ago. Now suddenly you’re seeing small investors squeezing the masters of the universe at hedge funds and they’re crying to the folks in Congress and the Whitehouse that they’ve been paying those huge speaking fees to that this is “market manipulation and must be stopped.” So, what’s going on here and does it mean anything to you if you’re investing and trying to build a portfolio? We’ll break it all down for you in this post.

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What is short selling?

Short selling is a way you can profit when a stock goes down in price instead of up. It works like this:

  1. You call your broker (or use the app) and say you want to sell 100 shares of XYZ corporation.
  2. Your broker will determine if they can get the shares of XYZ and if your account and trading experience is appropriate to let you take the risk of short selling. Note, they’ll let you lose money, they just want to make sure they can’t get sued if you do.
  3. You broker will go out and find an account that owns 100 shares of XYZ and that is currently “in margin” – they owe money to their brokerage firm. Their brokerage agreement (all that stuff you flipped through when you signed up) says that the brokerage can borrow their shares if they are in margin. (Note, they might also get the shares through a market maker or something, but let’s keep this simple.)
  4. Your broker borrows the shares and then sells them in the market. This can be a market order or a limit order, depending on what you enter (and you entered a limit order, because you’re not stupid, right?)
  5. The broker puts the money from the sale in your account, but also adds that you owe 100 shares of XYZ. If you leave the money in the account and XYZ stays at the same price or goes down, the sales proceeds and the shares you owe will wash. If you spend some of the money or the price of XYZ goes up beyond the money you have in the account, however, you’ll be in margin and start paying margin interest to the brokerage firm. The higher XYZ goes, the more interest you’ll be paying.
  6. IF XYZ pays a dividend and one comes due, you’ll need to pay the dividend for the shares you borrowed, which will be given to the person from who you borrowed the shares and who has no idea his shares were borrowed. For this reason, shorting shares of stocks that pay big dividends and leaving the position open for a long period of time are bad ideas.
  7. At some point in the future (it could be years), you tell your broker you want to “cover” the position, which means you want to buy back the shares. If XYZ has gone down in price, you keep the difference. If it has gone up, you’ll need to find money elsewhere to pay for the difference in the share price.

Why short selling is risky

At first glance shorting a stock may seem no more dangerous than buying long. Really, the chance that a stock you buy today will go up and that it will go down next week are about the same. In fact, stocks tend to go down much faster than they go up, so buying long almost seems riskier than selling short. But short selling is far riskier. Here’s why:

  1. When you buy a stock, all that you can lose is what you invested. If you sell short, there is no limit to how high the stock can go. If you had sold 100 shares of GameStop short at $2 per share back in November, you would have collected $200 but would owe $40,000 when it hit $400 per share this week. If you had bought a stock for $200 and it went bankrupt, you’d just be out $200.
  2. When you start losing money on a short sale, your position gets bigger. If you buy a stock and it goes down, it becomes less and less of your portfolio. If you short a stock and it goes up, it dominates your portfolio more, eventually consuming it if it goes high enough.
  3. If you buy a stock and it goes down, you can just hold as long as you want and wait for it to recover, assuming the company doesn’t do bankrupt. If you short a stock and it goes up, you’ll start owing margin interest (or need to tie up cash in your account to prevent paying margin interest). You’ll also need to pay any dividends owed even if the stock goes down. This means you need to not only be right, but get the timing almost perfect.
  4. Because short sellers are considered evil, the laws are against you. First off, you’ll pay more in taxes going short than holding long. If you hold a stock for more than a year, you’ll pay a lower capital gains rate. If you short a stock, no matter how long you hold the position, you’ll always pay the higher capital gains rate. You also can’t short a stock on a downtick in price because of regulations designed to prevent people from running a stock down in price.

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While short selling isn’t something good investors should do except under extremely rare circumstances (like before the 2008 mortgage meltdown), it is good to be aware of short selling on your positions, particularly when you’re buying into a company. The percentage of the shares that are sold short at any given time for a stock is published and called the “short interest.” Having a high short interest is normally a bad thing since it means a lot of sophisticated investors think the stock is due for a fall, so if you see this, you should reevaluate the company’s finances and look around for news articles before you buy in. There could be something like a scandal or another big issue about to break, causing the short sellers to act.

What is a Short Squeeze

So, what exactly is a “short squeeze?” A short squeeze is a form of market manipulation where people take advantage of short sellers to make a quick buck. People who want to do a short squeeze go out and find stocks that have a lot of short sellers. They then buy shares, which drives the price of the stock up.

Because many short sellers will set a stop loss (an order in this case to buy the shares back and cover the position if the stock hits a certain price) with a limit a little bit above the price at which they sell short, buyers know that if they can move the price up a little, these buy orders will kick-in and push the price up further, resulting in a quick profit for the buyers and a loss for the short sellers. (Note, for this reason, if you are ever short, you should watch the position like a hawk and just sell if it goes against you instead of setting a stop loss order. Better yet, don’t sell short. You can buy a put option for protection, or just sell some shares if you need the money fairly soon and are worried about a crash.)

In a short squeeze, this is taken to extremes where there are a lot of shares sold short. If the buyers can get the price high enough, the stop loss orders get triggered and push the price still higher. Then as the price goes up, the short sellers that remain start to see their losses and cover their positions to prevent the losses from getting bigger, driving the price up even more. Then, if the price goes up enough, the short sellers start to get margin calls where they have borrowed as much as their brokerage will let them. They then either need to add more money to their accounts or cover their positions. They then need to cover regardless of the price, which pushes the shares up even further in price. If there are a lot of shares sold short and not that many people selling them, share price can increase dramatically.

What about GameStop?

GameStop started out with a bunch of hedge funds, to whom very wealthy people give their money to speculate and who both buy and short stocks, doing the common practice of finding a stock that is on its last legs, selling a bunch of shares short, then talking about what a bad company it is and why it should go under. By selling lots of shares short and creating bad press, they are hoping to make a profit on their position. Note, this is also a form of market manipulation, so they are not angels here.

In this case they chose GameStop, which is a company whose business model is largely obsolete since most people get their games online electronically and not physically through a store anymore. The hedge funds figured that they could sell a bunch of shares since the price was so low, then push the company down into bankruptcy or at least to pennies a share and make a profit. This often works for them, but it was a really stupid thing to do. At $2 per share, even if the short 50 million shares, they can only make $100M. If the stock goes up to just $5 per share, they would lose $150M. It would make a lot more sense to short a stock like Tesla, which is insanely over priced right now with a PE ratio of 1255 and a share price of $800, so it has a lot of room to fall and would have difficulty climbing further (not that it won’t, because it is a cult stock). Anyway, stupid is as stupid does, and they shorted a whole lot of GameStop, to the point where about 90% of the shares outstanding were borrowed and sold short! A short interest of 10-20% is big, this is insane!

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Enter the Reddit speculators, a group of small day traders who got upset to see their beloved GameStop stock targeted. They decided that they would show the big hedge funds and buy shares to push the price up. Since the stock was only at $2 per share, they could buy lots of shares and lock them up, leaving fewer shares for the big hedge funds to buy back. The stock went up and triggered some stop losses, causing the shares to go higher. This got publicity, causing the stock to go higher. The hedge funds started to lose lots of money and it turned into a David vs. Goliath story, causing more people to buy in to support the cause and the stock to go higher. People started seeing others turn $50,000 into $15 M in a month, causing more people to buy in hoping to make a quick buck, causing the stock to go higher. The hedge funds started getting margin calls and needed to buy at whatever price, causing the price to go higher.

Last Thursday the stock touched upon $482 per share before settling down in the high $100’s. It actually had a range for the day of $112 to $482! On Friday it jumped again, closing above $300 per share. Hedge funds have lost billions of dollars and the SEC is investigating for market manipulation. Note that short squeezes are a common occurrence (the hedge funds do them themselves) and aren’t often investigated, but this is such an extreme example and the folks who lost money have friends in Washington , so an investigation is ongoing.

What does this mean to you?

If you’re investing the way you should be, this should mean nothing to you. These kinds of things are the short-lived price phenomenon that can’t be predicted and should just be largely ignored. You should be focused in on long-term growth which is far more predictable. If you were to own a stock that saw a short squeeze like this, pushing it up to the point where there is no way the earnings could justify the price anytime in the next ten years, you should sell out and put the money elsewhere. Otherwise, it is just one of the weird things that happens sometimes and means nothing. If you were to try to buy in after you see a short squeeze occurring, you are just as likely to buy in near a top and lose a bunch as you are to get in early enough to make a quick profit. Stick to the places where you can put the odds way in your favor.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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