You have probably heard about the famous GameStop ($GME) case, in which Reddit’s forum members managed to skyrocket its price. But what really happened? The answer is: a Short Squeeze.
First of all, we have to be clear about how short-selling works, and how it differs from buying long. Let’s see it with two examples:
Let’s imagine that Luka has $100 in his broker’s account, and he buys 10 GME shares at $10, so that in his account he would have $0 of cash and 10 GME shares.
From that moment on, if the price of GME goes up, Luka will make money, and if it goes down he will lose it. But beware, his potential profit is infinite since there are no limits for the rise of GME, but on the contrary, his loss is limited since GME can not trade below $0.
Now let’s imagine that Luka, who has $100 in his broker, wants to short GME shares at a price of $10. Since he does not have GME shares in his portfolio, he needs the broker to lend him those shares. The transaction that would be carried out would be the following:
- The broker lends Luka 10 shares of GME. Thus, Luka contracts a debt with the broker, which he must repay in the future by returning those same 10 shares.
- Luka immediately sells those 10 shares on the market at a price of $10, thereby putting an extra $100 into his cash account.
- Therefore, Luka ends up with $200 in cash in his broker’s account, and a debt of 10 GME shares (reflected in his broker’s account as a position of -10 shares on GME).
- For each day that passes without Luka paying off his debt, the broker charges him some fees for that loan.
If we compare this case with that of buying long, we see that now the maximum profit that Luka can achieve is limited to $10 per share (since GME cannot go below $0). But, on the contrary, his maximum loss is infinite!
Yes, you read correctly — infinite loss —, if GME stocks go up more than 100% Luka would lose more money than he had deposited in the broker.
Let’s do the numbers: if the price of GME rise to $25 (150%), it would cost Luka $250 to buy back the GME shares that the broker lent him, and remember that he only had $200 (initial $100 + $100 from the sale of the loaned shares), which would require him to enter another $50 to the broker.
In the previous example we have said that Luka could lose more money than he had initially deposited in the broker, and that in fact, if the price of GME rise to $25 he would lose an extra $50 to the initial $100. But in practice, this is not the case.
When you sell stocks in short, or you trade with leverage, the broker requires you to meet certain margin requirements.
So when the net liquidation value of your portfolio stops covering those margin requirements, the broker forces you to put more money into the account or close part of your open positions until you meet those margin requirements again.
In case you do not resolve this within the stipulated period, the broker itself will close your open positions at market. This is what is known as Margin Call.
I do not want to go into more details about how these guarantees are calculated, since it would be a whole post — if you are interested, do not hesitate to let me know in the comments. But remember the following:
When we short a stock, when we borrow shares, if we start to lose money we will be obliged to buy back part of those borrowed shares.
Now, once we have clarified how short-selling works, we are going to explain what a Short Squeeze consists of.
- Shares Outstanding: total number of shares of the company.
- Shares Float: shares that are available for investors to trade (subtracting insiders ans employees shares).
- Short Interest: shares that have been sold short but have not yet been covered.
- Short Interest % or Short Float: is the proportion of shares sold short by the number of shares available for trading. [Short Interest / Shares Float]
What is a Short Squeeze?
It is called Short Squeeze when the price of a stock begins to rise dramatically, because there was an unusual proportion of shares sold short (very high Short Float), and these sellers had to start buying back part of their shorts to avoid a Margin Call.
These buybacks of short positions in turn cause the price to rise more, which causes more short-sellers to be force to cover their positions… thus entering an uncontrolled upward spiral.
Stocks that are susceptible of a Short Squeeze are those that have a very high Short Float.
GameStop is a company that sells videogames in physical stores, so its business prospects are not very good due to the digitalization of the industry.
This caused many Hedge Funds to short GME, causing the Short Float to reach values above 100%. There were more shares sold short than its Float Free — naked shorting.
In a Reddit forum (Wall Street Bets) users noticed this situation, and conspired to start buying all shares of GameStop. This caused the price to start rising very quickly due to the liquidity problem that there was in GME (there were practically no shares in the market, all were borrowed short).
This initial rally was what triggered the Short Squeeze, as Hedge Funds that were shorting GME had to start buying back part of their short shares to meet their brokers margin requirements.
The result of all this is that GameStop went up from $20 to $480 in just two weeks, which means a rise of 2,300%!
Feel free to research in the next chart the best possible strategy to take advantage of the GME Short Squeeze. And, please, share them in the comments section!