GameStop short squeeze
Most of us could not have missed this topic on the headlines even, if we had no interest in finance. I thought that short squeeze would be a great topic to write about since most likely quite a few people did not understand the news 100% perfectly. This inspired me to write a few words about what a short squeeze is and how it is created.
What is a short squeeze
Short squeeze was on the news everywhere, but I did not see media giving any explanation what concept actually means. It sounds more complicated than it actually is.
It all starts with large short positions
For a short squeeze to happen there needs to be a assets, usually a stock, that has very high short interest position.
Short interest is usually measured as percentage of company’s outstanding stock. For example in early 2020 Tesla was the most shorted stock on the U.S. exchanges (18% of outstanding stock in short positions) and the latest example was in January when GameStop short positions actually exceeded 100% of the outstanding stock.
The short-sellers focus on companies that they believe will decline in value and borrow shares of these companies from the market. These borrowed shares have a specific expiration date and the short-seller will pocket the difference between the initiated short price and the actual sale price.
Trigger for positive share price movement
With large short position on a stock the expectations are poor for the company’s performance. However, for a short squeeze to happen there needs to be a trigger for the share price to start increase. This might be company beating the results expectations, positive news or something else that excites investors.
What happens, if the share price starts to increase? The short positions are turning into losses and losses start to accumulate, if the rally lasts. Short-sellers have two options: they can either keep their short position, if they believe that the share price will decline before the short position expires or they can close their positions. Generally most close their position at a loss.
Short squeeze is triggered
To close their short positions before the expiration date the short-sellers start to buy shares. Here the rule of demand and supply kicks in. The increased demand will kick in and the share price will rally. Increasing share price will force more short-sellers to close their position and buy shares, which will further support the rally.
The initial share price improvement started the short squeeze, which was further fueled as more and more short-sellers were forced to close their positions. In essence, that is what short squeeze is all about.
Trading short squeeze
It is very risky to bet on short squeezes and I would not call it investing. Contrarian investors find companies with very high short interest position that could provide short-term share price rally in the event of short squeeze. Usually they will first screen a short squeeze list and jump in, if some of the stocks is picking momentum in the market.
It should be noted that sometimes short squeezes do happen and offer excellent returns, but many stocks are shorted for a fundamental reason and will keep falling. In these situations the attempt to benefit from potential short squeeze situation by buying shares will only result in losses.
What happened in the GameStop short squeeze
GameStop short squeeze was unique as it was caused by large number of retail investors betting against hedge fund’s short positions. Retail investors realized that the short interest in the stock reached ~140% of the outstanding shares. Investors started buying the shares and discuss the topic on WallStreetBets that had 2 million subscribers.
GameStop share price started rallying as the short squeeze was triggered and this was further fueled by the fact that many of the retail investors held their positions and did not sell the shares. This resulted in decreased free float, shares available for trade on the market, and created further volatility in the stock as the demand increased.
Hedge funds short positions resulted in massive potentially multi billion losses. Finally a chart showing the actual share price and volatility changes. Crazy stuff.
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