What is it that can put a stock on a meteoric rise? In 2021, we saw a number of stocks make truly staggering jumps, doubling in price on consecutive days. There are several factors that contributed to these gargantuan moves, but one is surely the classic short squeeze.
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While there are some new factors at play in the markets today, the short squeeze has been around as long as shorting stock.
What Is A Short Squeeze
Here is how the short squeeze works. If traders think a stock’s price is going lower, they can short the stock. They borrow shares and sell them, with the intent of buying them back at lower prices.
This is mostly done by institutional investors, like hedge funds, given the risks and the margin required.
And there are big risks. Stocks can theoretically go up infinitely. So a trader who is short can face theoretically infinite losses.
Some stocks attract very high short interest, which can be viewed as the amount of shares sold short as a percentage of float, or how much stock has been issued that is available for trading.
The problem comes if the stock prices starts to rise quickly. Those that are short the stock will likely receive a margin call. They either have to put more money up to secure their position or close their positions.
If they choose to — or are forced to — close their position, they are buying the stock to close. This can push the price higher and force other short sellers to do the same. This creates a reinforcing loop of buying and pushing the price higher. This is the short squeeze, as those short the market get “squeezed” out.
Short Squeeze Stocks: GME
This is definitely part of what was happening in GameStop (GME) stock. In August of 2020, GME stock was trading for around 4.
Shares steadily climbed to close out 2020 just under 20 on the back of some big name investors taking stakes in the company. This attracted the short sellers, notably some big hedge funds. Then, on Jan. 13, 2021, the stock jumped to hit a high of almost 40 on huge volume.
That was surely the start of the short squeeze. That 40 level held for about a week. On Jan. 22, the stock jumped again, trading above 70 on the biggest volume day up to that point.
The next day the stock hit a high of almost 160 with similar action the next day. Then on Jan. 27 the stock doubled again, trading up to 380. The Jan. 28 high was 483.
While short squeezes are nothing new, this action is unprecedented. The action is certainly partly stock buying by the Reddit group wallstreetbets.
And while many cheered that the little retail traders were beating up the big institutional shorts, it is pretty clear that other institutions were also in on this buying. Stories have popped up about Michael Burry’s gains on GME stock and Elon Musk was tweeting about it.
Hedge Fund Losses
There were some big losses in this squeeze.
Two funds in particular were hard hit. Citron Research and Melvin Capital have reportedly suffered huge losses.
The short squeeze is usually something inflicted by one hedge fund on another.
This is really the first time we have seen such trading instigated by a band of retail traders.
Options Trading Is Also A Big Factor
Another piece of this story’s plot is the fact that much of the trading in GME and other names like AMC Entertainment (AMC) and BlackBerry (BB) was actually taking place in the options market.
Bullish call buying instead of buying the stock is attractive here because of the leverage it provides and the fact that risk is limited.
Calls are contracts that give the right to buy the underlying stock for a given price (strike price) until the expiration date. The most that can be lost is the premium paid for the calls.
Buying calls requires much less capital, so bigger positions can be taken by small traders.
This actually adds to the short squeeze effect.
When retail traders buy calls, it is market makers that sell them.
The market makers don’t want the risk of being short calls, so they do something called delta hedging.
What Is Delta Hedging, And Why It Matters In A Short Squeeze
Delta hedging requires the market makers to buy stock. And because of the nature of calls, when the price of the underlying stock goes up, the market makers have to buy more stock to stay hedged.
We might call this the call option squeeze.
The problem is that these moves are not based on any fundamental changes in the stocks.
Not much has changed for GME stock since it was a $4 stock, and certainly not since it was a $16 stock.
Brokerage firms are very concerned about the volatility of these moves, as they know they may face losses if customers can’t cover positions. They started limiting the positions that can be taken in some of these names.
That news came on Jan. 28, 2021, which saw GameStop stock price range from over 500 to below 115.
This is a trade you wanted to watch out for. While some hedge funds were hurt and some retail traders made fortunes — at least on paper — this still may end badly.
The helium holding these stocks up would not last forever.
This article was originally published Oct. 12, 2021, and has been updated.
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Source: https://www.investors.com/how-to-invest/investors-corner/short-squeeze/?src=A00220&yptr=yahoo