What is a short squeeze?

What is a short squeeze?

Have you been following the amazing story that’s been unfolding with the Gamestop / Reddit / Hedge Fund short squeeze story?

I betcha! Let’s look at what a short squeeze is.

Have you read the important notes? It’s a condition for reading the blog. 

Gamestop

Gamestop shares have surged unbelievably in the last few days – rocketing from around $40 a share a few days ago to closing at almost $150 (over $200 in after market) at the time of writing. 

Yeah, Gamestop. 

The bricks and mortar store. 

That sells computer games. 

In an age where everyone downloads games through Steam, Xbox store or other digital outlets. 

It’s difficult to understand right? How is that a good business model?

Check out the stock chart below!

Gamestop

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I could imagine Gamestop being a clever deep-value purchase at $4 a share, but when it’s trading at over $100? 

Clearly something must be going on. But what?

Short Selling

For a while Gamestop has been the target of ‘shorting’ or short sellers.  

These are large institutional investors, like hedge funds, who are taking a bet that the stock will go down in price. If Gamestop goes bankrupt then they win. 

If you buy a stock, then you are ‘long’ the stock. In this case you own +1 stock. By shorting a stock you have -1 stock and will profit if it loses value. 

Huh? 

To understand the latest carnage we first need to understand how you short a stock.  

How To Short a Stock

A short seller will first borrow a stock from another investor. And that investor is probably you. 

Many passive funds will lend out stock. They don’t do it because they love hedge funds, they earn interest from the borrower. How do you think managers obtain those super-low passive management fees? One way is lending securities. This lending income can help offset costs and provide low fees to the retail investor. 

The short seller immediately sells the stock and pockets the cash. They are then hoping that the stock now drops in price and when it comes to returning the stock to its rightful owner, the short seller can purchase the stock for less than was paid, thus realizing a fat profit. 

Sounds easy, right?

It’s a great strategy if the stock price falls. But if the price rises then for the short seller it’s squeaky bum time.

The short seller will be nervously watching the price rise knowing that to return the stock to the lender will require a bigger payout.  

The Squeeze!

And this is where the squeeze comes in. 

If the short seller thinks the price may not fall below the purchase price then the only way to stem the losses is to bite the bullet and purchase the stock in the open market. Alternatively the terms of the lending agreement may require purchase if the seller’s losses exceed a certain point. 

In any event, the short seller holds -1 stock and the only way to neutralize this position is by purchasing a stock – which is +1. 

What we’ve seen in recent days is a Reddit group pump the Gamestock stock urging their readers to buy and then hold. 

This has two effects – buying increases the price through demand, and by holding the stock makes the supply less available for short sellers. 

The sharp increase in price has forced a number of hedge funds to exit their positions – crystalizing huge losses – and buy stock to cap further losses. 

And guess what? 

Forced buying has further forced up the price. This feedback loop was on full display, and I’m not even sure “exponential” captures the growth rate we saw last Friday just before the market closed.  

But There's More!

Since Friday we have seen more wild ups and downs with this feedback loop. 

Some short sellers are doubling down. After all, if you thought this was a stock worth shorting at $40, then it’s a sure fire winner to short at $150!

But of course, the Reddit crowd have smelled blood. One hedge fund (Melvin Capital Management) has already sought billions of dollars of bailout money to shore-up it’s 30% losses.  The Reddit group have been urging its members to further push the stock higher. 

Other exogenous factors keep this story interesting with Elon Musk tweeting “Gamestonk“, which will no doubt add fuel to the fire. 

Call Options

One final point is that many of the Reddit investors are seeking long exposure with out-of-the-money call options. These provide the holder with the right to buy a stock if it exceeds a certain strike price. 

If the stock goes up then these call options suddenly become very valuable. It’s a way to get exposure to stock price rises without owning the stock. 

And if you are the broker that sold the call options? How do you hedge yourself against these potential losses?

Yep – you guessed it, you need to buy the stock!

More fuel for the fire. Oh boy!

Short squeeze

What A Story!

This tale will be made into a movie at some point. 

Or at the very least a Michael Lewis book.

There are so many aspects of this story that I haven’t touched on; including the narrative of a David versus Goliath battle of ridiculed day-traders facing up to billionaire hedge funds, or the social-economic angle of people using their stimulus checks to fuel a guerilla war on The Man.

This story has it all. But I wanted to give you a quick overview of some of the financial mechanics driving this. 

I’m not advocating that you join this craziness, and if you do, please just treat it as “gambling money”. Don’t put the kids’ college funds on this! 

But if you do, enjoy the ride and drop me a note to tell me how it all turned out!

Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post. 

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