“Who is short, and why are we squeezing them?”
The famous line from Hamlet offers a simple consideration.
“To squeeze or not to squeeze, that is the question.” Or, something like that. The talking heads on CNBC and Fox Business haven’t been talking about their favorite Shakespeare. No, they’ve been spending their time obsessing over a market phenomenon called a short squeeze. To understand what the big fuss is all about, we first have to understand what different terms mean in this situation. Let’s answer the question once and for all, what is a short squeeze?
- Gamestop (NYSE: GME) recently experienced a short squeeze, with its price rocketing to an all-time high of $483 per share in early 2021. For reference, at the end of 2020, shares could be bought for $18.84 a piece. Put your calculators down, we’ve got you covered. That’s a 2,463% increase in the course of a little over a month.
- The driving force behind this squeeze was a reddit community, r/wallstreetbets, a collective of small-cap retail investors.
- Other prominent short squeezes in recent memory include Volkswagen (VW), who in 2008 briefly became the biggest company in the world as a result of its stock being short squeezed.
What is a short squeeze: Terms to know
If you’re looking to sound intellectual when discussing short squeezes the next time your in-laws post something on Facebook on the subject, there are a few terms that you’re going to need a handle on.
Short: If an investor is short on a stock, they’re banking on its market price taking a turn for the worse. Investors can make good money by shorting a stock, but as with any type of investing, it has its risks. When individual or institutional investors short a stock, they borrow shares from their broker and sell them. Then, when the stock (hopefully) falls in price, they buy shares to replace the borrowed ones, and are able to pocket the difference in price.
Long: If an investor is long on a stock, that means that they are holding the stock as a part of their portfolio with the hope that the stock will rise in price, making their position more valuable as time goes on.
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A short squeeze in action
So, how does a short squeeze come to fruition? It’s something of a perfect storm, and we can look back to the 2008 Volkswagen short squeeze to see the trajectory of this kind of storm.
October 2008 was during the height of the Great Recession, and VW was struggling to stay afloat as the economy took a tumble. Investors took note of this and began the process of shorting VW in an attempt to take a profit off of the company’s downturn. A short squeeze is often spurred on by surprise news about a company, and in Volkswagen’s case, it was the news that Porsche was increasing their ownership of VW up to 74%. When investors who were short on the stock heard this news, they quickly tried to close their position, which can only be done by purchasing shares from the market.
Roughly 55% of shares of VW were already accounted for (i.e. they were already owned by investors). Porsche, as a result of increasing its stake in VW, increased that number to nearly 99%, leaving only 1% of shares available for short sellers to purchase in order to close their positions.
As hedge funds holding short positions rushed to buy up shares, the price of VW stock shot up—fast. As a result, money pumped into the company, to the tune of over $10 billion in profits.
Hedge funds experienced the opposite result, losing a total of over $30 billion as they raced to cover their shorts. But, VW’s sudden rise to the top was short-lived. In a matter of only four days, their stock fell 70% returning to levels much closer to what they were before the squeeze.
How to know what’s coming in a short squeeze
Investors can access a wide variety of stats and indicators on any given stock. One, called short interest, can be critical in knowing when a short squeeze may be on the horizon.
Short interest is simply the percentage of assets that are currently being held in short positions (being borrowed from brokers in order to take a short position).
A higher short interest is generally considered to be a good indicator of a possible short squeeze impending.
Another indicator that may alert to a short squeeze is a stock’s Relative Strength Index (RSI). This indicator shows when a stock is considered to be either oversold or overbought relative to the market.
When the RSI of a security creeps below the number 20 in the index, investors consider it to be oversold. An oversold stock is often due for a reversal, pushing the price in the opposite direction that it has been trending. When the stock’s price starts to increase, investors will likely begin to purchase it. WIth enough buying power behind the interest in purchasing, there is a chance that this movement can work to push out short sellers.
When shorting a stock, things can go poorly for those who hold those short positions. The downfall can be fast, too. The decision becomes a complicated one, as the marks operate in a cyclical manner.
So, should short sellers hold their positions, and risk the price continuing to trend upward before their shares are due back to the brokers that they borrowed. Alternatively, when the price of the security being held increases, the short sellers can buy their shares back to close their position, risking a smaller loss, but giving up the possibility of the stock decreasing in price again.
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Short selling stocks can spell trouble for investors in quick fashion. This is why (usually) only larger entities, such as hedge funds or big institutional investors, hold short positions.
The math is simple. When holding a long position in a company, there is no limit to how much money that you can make from it. There is, however, a built-in stopping point of zero, as a share of a company can never be worth negative money.
The opposite is true for short positions. The most a short seller could (hypothetically) make on a short position would happen if the stock tanks in price, down to a penny or so. It should be noted that this pretty much never happens. Not to say that it can’t, but we haven’t seen it yet. A short position doesn’t, however, have a cap to the losses that it can incur if the investor’s view on a security (bearish or bullish) turns out to be wrong.
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Regardless of what happens with the shorted asset, the broker will still want their shares returned to them. And quite frankly, whatever price you have to pay to get those shares back in your portfolio isn’t their concern. As such, shorting is a dangerous game, and as with any other investments, you should be sure to do your due diligence before putting any money into any security.