Everyone in 2021 got a fast primer on the power of a short squeeze, but what actually causes this cascading effect?
- Short selling is betting that a stock will fall in value.
- A short squeeze is a cascading effect caused by a rise in share price.
- Short selling is extremely dangerous with a potential for infinite losses.
Selling a Stock Short
Stock shorting, also known as "selling a stock short," is the act of borrowing a stock to sell it at the current market value. The borrower then hopes the market value of that stock will decline, allowing them to buy back the stock at a lower price to return to the person they originally borrowed it from.
In moderation, this is a perfectly legal and good force for the market because it can provide a counter to nefarious investors trying to hype a stock ("pump and dump").
Like anything in life, a good tool can be used to ill effect. The opposite of "pump and dump" is when short sellers actively spread misinformation to unfairly crush the value of a stock that they have taken a short position in. This allows them to temporarily depress the share price and cash out.
In extreme cases, this artificial influence can even destroy the company being used in this parasitic manner. Shorting in this manner is illegal.
A short squeeze is when a shorter is forced to buy back a stock they borrowed at a now higher price caused by a lack of collateral to absorb any more potential losses from the stock moving even higher. When the shorter buys back the stock at the high price, it can drive the share price even higher.
The root cause of a short squeeze happens when the price of a stock rises far above the price the stock was originally shorted at, leading the shorters (the borrowers of the stock) into exponentially rising potential losses.
As these potential losses rise, a brokerage company will assess whether the shorter can absorb the exponentially increasing potential losses from this share price increase.
If the brokerage company has doubts about the investors ability to absorb the losses, the brokerage will issue a margin call - forcing the investor to either deposit more cash (or sell other stocks), or be forced to close their short position immediately at the new higher price.
Short Squeeze at Scale
In isolation, a few shorters forced into a short squeeze will not materially change the overall market.
However when a stock has a high short interest (i.e. a large proportion of shares that have been sold short), this can lead to a compounding effect where a small increase in share price can force a cascading effect of shorters being forced to buy shares at the higher price, driving the price even higher, and triggering additional shorters to be forced to close their shorts as well.
This cycle can go on and on in an exponential fashion as the share price continues to grow, squeeze shorts, and gain speed.
In extreme cases, a stock may even be shorted to over 100% of available shares. While this may sound shady, in fact it only means that the same stock may have been borrowed multiple times and sold short. This can artificially depress a stock price, but also exposes the shorters to a much higher risk of a short squeeze.
What stops a short squeeze from going to infinity?
- As the price of the company goes up, the increasing market cap of the company requires ever greater amounts of incoming cash to continue to bid up the price to continue the short squeeze. This scenario makes a percent increase in share price "cost" more to achieve the same effect.
- As shorters are forced out of the market, with losses, they are replaced by new and fresh shorters. These new shorters are now starting their short positions at the new higher and potentially inflated position - meaning higher potential gains when the stock crashes.
- As a share price gains, regular investors will be motivated to sell for high gains. This releases more shares into the marketplace and reduces the pressure on the increasing share price.
The 2021 Gamestop (GME) Example
Timeline of a Short Squeeze
- 2018-2019 - Short sellers identify that Gamestop (GME) is a weak company with an outdated business model. They believe the stock will go down, and begin to short the stock.
- Late 2019 - Some investors notice that GME has an extremely high short interest - above 100% of total shares. They also believe GME is undervalued and the share price can gain. They begin to invest.
- Early Jan 2021 - The stock reaches a critical mass as it gains the interest of a large number of investors in a community forum. The price begins to rise rapidly.
- Mid Jan 2021 - The short squeeze begins to hit short sellers as the share price continues to double and triple. Many shorters close their positions, taking huge losses, and driving the stock even higher.
- Late Jan 2021 - The stock gains attention nationwide and spikes to extremely high values. The higher values and attention draw in more investors who continue to buy at elevated levels, continuing to push the stock higher.
Unless you are an advanced investor, stay away from shorting a stock. The potential for exponentially increasing losses is a very real risk that has bankrupted many experienced traders.
A professional hedge fund involved in shorter can employ advanced strategies and hedges (hence hedge fund) to safeguard from complete bankruptcy, but more importantly even a total collapse of the hedge fund won't bankrupt its owners.
An individual investor does not have those safeguards and could loose everything.
If you happen to find yourself on the up side of a short squeeze as a normal investor, remember that it is a temporary effect that will eventually return to its fundamental basis. Most stocks that are caught in this effect and skyrocket in value will return back to their true, much lower value just as fast. A smart recommendation is to take some gains off the table as the share price rises.