What is a short squeeze and is this a common phenomenon?
Before we can get to answering what a short squeeze is, we need to answer some preliminary questions.
Let’s start with what is short?
A short is a position taken by an investor or trader making a bet that an asset’s price will go down, not up. On average, under 5% of the S&P market capitalization is shorted. Most participants in the stock market invest because they believe US stocks will go up over time. Shorts are a very small group of investors betting against most other investors’ view of the direction in the market and as such, are viewed with disdain.
A stock can go to zero but it can also theoretically rise to infinity. From a short’s perspective, the maximum gain is 100% if it does go to zero but a downside of “infinity” if a stock keeps on rising. Upfront risk management and timing of a short position becomes extremely important.
Who does shorting?
Shorts positions are often executed by hedge funds (and within it long/short, risk neutral or multi-strategy funds) and we will concentrate on them here.
Hedge funds charge the highest fees for managing other people’s money by claiming they can pick stocks on the long and short side irrespective of the general markets direction and thus consistently beat the market indices (provide a “hedge” of sorts).
Hedge funds also report their results monthly and yearly to investors. Unlike long investors, who have a diverse set of timeframes, shorts from hedge funds have a “shorter” time window to work compared to longs (like a ticking time fuse given their reporting windows).
What are some reasons to short?
Fraud or accounting manipulation is the most fundamental reason to bet against a company and its price. Examples are Enron, Worldcom, Lehman Brothers, and Lukin Coffee. These are extremely difficult to find.
The more common reason hedge funds bet on stocks going down is because of excessive short-term expectations or negative catalyst events around the long-term terminal issues with a company. Hedge funds challenge the long investors’ consensus views arguing the company and its stock should be a lot lower due to forces like competitors, new technologies or other disruptions. When longs understand these risks, the shorts believe the price will decline as longs will sell the stock.
Again by shorting (and being different to the vast majority of market participants), hedge funds believe they are “hedging” certain risks and provide a differentiated product offering to their investors.
How do you execute a short trade?
The fund has to borrow shares from brokers, who will loan the stock to them (from their other clients who are long the stock such as pension and mutual funds), for an interest charge. This interest cost can be as low as 1% per annum or as high as 30, 40 or even 50 percent. After the funds secure the borrow, they then sell these shares on the open market, hoping to profit when they buy the stock later at a lower price.
Now, onto the short squeeze – what causes a short squeeze?
Generally one or more of three things occur.
1. When a stock price goes up, instead of going down, the short naturally feels pain. Remember the short’s bet is that the stock will go down. As it goes up, the hedge fund is feeling pain (mark to market losses, higher collateral to hold the short and psychological effects). As the stock keeps going up, the losses and pain rapidly increase to intolerable levels (as risk limits expand beyond reasonable limits). For survival reasons, a hedge fund may be forced to buy back a short even if they fundamentally believe a stock should be lower and sell other long positions in their portfolio completely unrelated to the short to reduce exposure (or de-gross). Other (long) investors may sense the fund that is short is in trouble and continue to buy to exacerbate the short-term demand of the stock (relative to supply) causing a squeeze in price as the short scrambles to cover (so called “blood in the water”).
2. Another way a squeeze occurs is a recall. A short has to secure borrow from a broker. Sometimes these brokers will recall shares, which mean the loan is automatically called against the short. Now you can’t borrow those shares anymore and you have to buy back into the market irrespective of the price (an example used in the Showtime TV show “Billions”).
3. A third way squeezes occur is if regulations suddenly change (the rules of the game so to speak). In 2008, certain governments banned short selling of bank stocks causing an artificial squeeze.
This forced buying, via a squeeze, is a very short-term phenomenon as once the short covers (buys back the shares to pay back the borrow) it extinguishes as the demand disappears. So being short a stock is very different from being long and is not the opposite of going long. Regulation, interest costs and less time to be patient are important differences.
Turning to the Gamestop short squeeze, we can see similarities and differences from the past.
Forums and collectives of individuals trying to work out what’s the best way to beat the market have existed throughout time. In the 1920s, there were pool rooms where people discussed stocks. In 1998 and 1999, there were Yahoo boards. Today we have Reddit.
In many cases, these boards target penny stocks due to their low dollar values so more people can participate. However, this time the Reddit forums added another criteria: the penny stock had to be heavily shorted criteria. What does that mean? For names like GME, KOSS, AMC the number of shares shorted were anywhere from 30% to over 100% of the float (much higher than the 5% short average we discussed earlier). This is an extreme level. AMC and GME were under $10, heavily shorted, and represented a seemingly perfect price point for individuals.
Another important wrinkle is that the Reddit forums also suggested buying call options in addition to stock. Now, on top of a short squeeze, buying significant call options can lead to a gamma squeeze thus creating an even faster (more extreme) feedback loop and price spike – a story for another time.
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The narratives around the shorting of Gamestop included “David vs Goliath,” “Wall Street against Main Street”, ” suits vs common folk,” etc. These labels represent an element of distrust that exists in the stock market by many of the retail participants. People are still reeling from their 2001 and 2008 experiences, where the big institutions got saved (“Too Big Too Fail”), and the perception that the little person did not get help. People want to get back at hedge funds who bet against the American dream.
But it is important to understand, we do know everyone behind this Wall Street Bets Reddit group (WSB). Some of them appear to be ex-hedge funders and ex-financial advisors, who haven’t made it in their own way, and are now going using this forum to utilize crowdfunding (and direct flow) to their idea.
The message and the effects of the short squeeze often get diluted and lose its efficacy like other protest situations. The original thesis of WSB was well constructed – penny stocks, extraordinarily high short interest – a far cry from the “dumb money” stigma often given to retail investors by Wall Street money managers as some kind of insult by the professionals.
However, the next group of people that got involved in the trade likely got caught up in FOMO or YOLO type strategies (momentum for quick profits out of envy). As Charlie Munger of Berkshire Hathaway said: “The idea of caring that someone is making money faster [than you are] is one of the deadly sins. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”
We will continue to hear about upcoming regulatory hearings and media reporting of hedge fund casualties. As John Maynard Keynes said, “the markets can remain irrational longer than you can remain solvent.” For example, Melvin Capital, apparently one of the largest shorts in Gamestop, was reported to be down 56% in the month of January. Melvin cut their short despite their belief in their Gamestop thesis to protect their remaining portfolio. They had a fantastic track record over the last 4 years.
Even experienced risk managers on the short side must consider the influence of retail traders especially in this post 2020 environment when things can rapidly move outside normal parameters into extreme (fat tail) events.
However, we do not yet know the effects on the long only retail players who saw this short squeeze dissipate. Seeing a life changing amount of money materialize on paper, then evaporate or turn into losses can have long-lasting psychological effects as it did for many in 2000 and 2008. 2021 may represent an even larger group of people, so we do know the scarring.
Some professionals did very well on the long side, essentially using the short squeeze to convert debt into stock and selling it to time the exit well. Executive management of the companies sold some of their stock compensation during this time as well suggesting the stock price surge due to the short squeeze was ahead of fundamentals. Curiously, we did not see much action from Gamestop board itself. Even Robinhood, which restricted trading on a pivotal day on January 28th due to collateral needs causing a massive outcry, saw its app downloads spike higher as it attracted more sign-ups.
So to summarize: Short squeezes to the extent of Gamestop are extremely rare events which are very difficult to manage and represent a short-term phenomenon. Visually, it looks like the graphs below with a spectacular covering of shorts (upper graph pane in image below) leading to a parabolic rise and a consequent 50-plus percentage point stock price drop (barely discernible in the bottom pane as the latter happened in less than 24 hours).
There is much more to learn as more details emerge. In the meantime, get ready for another finance movie. We had Wolf of Wall Street, Wall Street 1 and 2, The Big Short and now a movie is reportedly in the works for the Gamestop trade/Reddit revolution after a script about the life story of one of the WSB traders was sold (not shorted).