Short selling, a short squeeze, and GameStop

Unless you’ve been completely cut off from the world recently you’ve surely heard about GameStop and the market activity in its stock, as well as a few others being targeted by a new breed of retail investors in a similar manner. But what is short selling? What’s a short squeeze? And why is this happening? 

The short

Short selling or shorting a stock is essentially a bet that the price will go down. Investors borrow the stock from a broker and immediately sell it at the prevailing market price. If the stock price does indeed go down, then these investors — labelled short sellers — will buy back the stock at a reduced price, “return” the stock to the broker to close out their short position and pocket the profits. 

The profits, in this case, are the difference between the price they “borrowed” the stock at from the broker and what they paid to buy shares in that same company later, when it’s time to repay the broker and close out their position. 

If the stock price goes up, short sellers have to decide whether they can mentally and financially afford to maintain that short position. If the price (and losses) keep going up, then the short sellers will need to top up their margin account

To close out the position, they’ll have to purchase the same amount of shares they initially borrowed. That means they’re out the difference between the price when they went short and the selling price of the stock when they covered or closed out. As a result, losses on a short position can be limitless. 

The short squeeze

When a stock price suddenly goes much higher, short sellers who expected its price would fall are forced to buy back the stock to stave off even greater losses. This panic buying only adds to the existing upward price pressure, leading to what’s called a short squeeze. 

Video game retailer GameStop quickly attracted attention in early 2021 as market watchers realized its stock was in the middle of a short squeeze perpetrated by retail investors who got together and forged a plan on a Reddit message board. The board behind the concerted purchases of GameStop shares saw its subscriber base double in little more than 24 hours, to four million users. 

This short squeeze has a bit of a twist because there was a considerable volume of options trading in GameStop, in a coordinated effort to drive the stock price even higher and enhance the gains for anyone on the right side of this trade. When there’s excessive use of options to ramp up stock-buying activity in this way, you’re dealing with a special type of short squeeze  called a gamma squeeze. 

Tesla was previously the biggest short squeeze in U.S. stock market history when, in February 2020, 25% of its outstanding shares were on loan to short sellers. During the financial crisis there was an epic short squeeze in Volkswagen shares, which briefly hit 1,000€, making it the single largest company on earth in terms of market capitalization. In that situation, hedge fund managers were left scrambling to cover their short positions. 

Hedge funds are well known for short-selling, but their short positions aren’t readily known to the outside world unless the fund managers discuss their strategies in the media or with anyone outside the firm. That being said, aggregate short positions by security are visible to market participants on any given day, and additional information can be cobbled together with materials like investor letters and trading reports. 

This appears to have been the case with Melvin Capital and Citron Research , which were sitting on considerable short positions in GameStop. Melvin reportedly disclosed its holdings of put options on the stock in a recent regulatory filing. Put options are contracts that give owners the right to sell at a specific price by a certain date, suggesting they believe the stock price will decline. The head of Citron, meanwhile, hosted a livestream session the week before the frenzy began, in which he forecast that the stock would be down 50%. Redditors pounced on this information and hatched a plan to work it to their collective advantage. 

It’s unclear if there was any other reason this stock became the chosen target, but a single Redditor started a thread encouraging others to buy the stock to put the squeeze on the hedge funds, which would only be able to maintain their short positions for so long in the face of a rising stock price. The more the stock price went up, the more the losses for the hedge funds and its investors would pile up. 

Melvin Capital was finally able to close out its short position after sustaining some $13 billion in losses. Citron Research stated that they lost 100% on this short sale. 

The battle 

In response to the extreme price moves and concerns about potentially over-leveraged investors, investment firms, trading platforms and brokerage houses increased margin requirements (in some cases to 100%), limited options trading and even outright banned purchases of stocks being targeted in this manner (the restrictions applied to stocks that included BlackBerry, Nokia, Beyond Meat, Koss and AMC Entertainment). 

Wall Street argued this kind of coordinated action by the investing public should be illegal, but retail investors’ retorted that the big firms were just bitter because they got beaten at their own game. The battle was framed in the media as David bullying Goliath, which is fairly uncharted territory for Wall Street. 

Buyer beware

Many of these retail investors simply jumped onto a trend with little sense of the fundamental value of these stocks, likely without any real understanding of just how much money they were at risk of losing.

Short sellers can bring new information to light, leading the market to a different assessment or discovery of a company’s prospects. This might keep a stock lower than if only the supportive voices are heard. The shorts can help keep unbridled enthusiasm in check. Sometimes they uncover fraud, questionable accounting practices, poor management, or information that was deliberately hidden in regulatory filings. All of these are valuable functions in the capital markets. 

Research has consistently shown that banning short selling during periods of heightened volatility only intensifies that volatility. These restrictions prevent investors from determining accurate asset prices and reduce market liquidity. 

The contradiction, some argue, is that when Wall Streeters benefit from the system it’s considered capitalism at work, but when outsiders benefit, it’s labelled manipulation. There are calls for regulators to get involved and this story is far from over. Social media and online trading platforms and apps ushered in a new era for retail investors. These new market players are able to widely share information and trade — for free — and they aren’t going anywhere — not while they still have shirts on their backs anyways. 

So, while this new version of an age-old market story plays out, hedge funds will have to think twice before building aggressive short positions and about how they do so without showing their hand. At least for now.

4 weeks ago

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