What is a short squeeze?
Short squeezes are nothing new. This occurs when the price of a shorted stock increases high enough that the seller is forced to take action. It isn’t difficult to find out which stocks have been aggressively sold short—short interest data is readily available. In order to short a stock, a trader must first ensure that it’s available to borrow, since short selling involves selling something you don’t own. A squeeze can hit short sellers with margin calls, making them put up new money to maintain their short position, which increases their costs and potential losses. It can also force short sellers to buy back, or “cover,” the stock they’ve sold in order to close out their position to avoid further losses. This action increases the price of the shorted stock. When multiple short sellers must compete to buy back the stock, this can drive the price dramatically higher.
Experienced short sellers are known for their detailed research and strong opinions, because their strategy is a particularly difficult one to execute successfully. After all, buying a stock risks “only” that the investor loses 100% of the price paid, since the price cannot go below zero. Selling short, as recent events have illustrated, can be far more costly, with no theoretical cap on losses.
This time it’s different
It’s not unusual for large investors to take opposing sides, with one selling short and the other trying to squeeze the seller by buying aggressively. High-profile activist investor Carl Icahn attempted—and largely succeeded—in squeezing another well-known activist, Bill Ackman, when Ackman was shorting the multi-level marketer Herbalife in 2013. But it is unusual for a community of small traders to collaborate and attack, successfully, a short position of one or more major hedge funds. But that’s precisely what has taken place lately, with members of the chat room “r/WallStreetBets” on the social media site Reddit teaming up to buy large amounts of relatively small but heavily shorted stocks. The populist aspect of this trade, during a time of social upheaval, has been difficult to ignore.
In a typical short squeeze, the buyer might be looking for a profit, for example, in the range of 50%-100%, sometimes less, sometimes more. But the numbers in this instance have been astonishing. GameStop shares closed on January 21, 2021 at $43.03, already well over twice their level at the end of 2000, and about seven times the price of early September. But that was small potatoes compared with what followed. On January 27, the stock closed at $347.51.¹ Short sellers were forced to cover at whatever price they could, regardless of fundamental valuation principles (or anything else).
Shorts versus longs
Short sellers typically look to make money in the near term, because over most (but not all) multi-year periods, the stock market rises. They look for a specific catalyst such as an earnings shortfall or a disappointing trial result for a new pharmaceutical. Long-only investors buy stocks, often intending to hold them for years, on the thesis that a company has a competitive advantage in a desirable business and will generate increasing cash flows over the long term.
Villain or enforcer?
It’s probably no exaggeration to say that the average individual doesn’t care much for short sellers. They make money, after all, when a stock goes down, which often happens because of troubles at the company in question. Most short sellers avoid shorting just because they consider a company’s shares overvalued, since a stock that can go to $100 can also go to $200, or $500, or any other price. Instead, they look for an intrinsic problem with a company’s products, services, or processes, including accounting fraud.
Short sellers discovered fraud at Enron nearly 20 years ago, and more recently, found that flooring maker Lumber Liquidators was using dangerous levels of the carcinogen formaldehyde.² Because they have risk/reward profiles far more dangerous than do long-only investors, short sellers have to do the kind of detective work that sometimes provides a social benefit as well as significant profits for the sellers. They’ve been likened to the “enforcer” on a hockey team: The player who rarely gets involved in a game unless there is a fight. When they succeed, short sellers enforce good behavior by companies by beating up those who go astray.
Who loses in a short squeeze?
Clearly, a hedge fund or long-short equity fund with a big short position in a stock that goes up 700% in a matter of days is in a lot of trouble. But the trouble may go beyond the fund’s own profits (or existence). Hedge funds often manage money for pensions and endowments. While a few “little guys” may be making big scores by creating squeezes—if they get out fast enough since the price is nearly certain to collapse—the losses they impose on hedge funds may be felt by a lot more little guys or retirees that have exposure to hedge funds via their employer’s pension plan.
1 Macrobond, 1/28/21. 2 cbsnews.com, 3/1/15.
A widespread health crisis, such as a global pandemic, could cause substantial market volatility, exchange-trading suspensions and closures, affect the ability to complete redemptions, and affect fund performance; for example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the fund’s performance, resulting in losses to your investment.
The value of a company’s equity securities is subject to change in the company’s financial condition and overall market and economic conditions. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States.
The Cboe Volatility Index (VIX) shows the market’s expectation of 30-day volatility and is constructed using the implied volatilities of a wide range of S&P 500 Index options.
It is not possible to invest directly in an index. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss.