Shorting a stock and short squeeze

In the world of trading, the norm is to profit from stocks that rise in value. However, there are a group of traders who prefer to take the road less traveled by employing a short selling strategy that capitalizes on stocks that decline in value instead.

Short squeezes: Unveiled

In finance, a short squeeze stands out as an exceptional phenomenon capable and refers to a situation where a heavily shorted asset (typically a stock), experiences a rapid increase in its price, forcing short sellers to buy the stock to cover their open trading positions, cut their losses and swiftly abandon their positions. This increased buying activity can trigger a self-reinforcing cycle, disrupting market sentiment and driving the asset’s price even higher.

Decoding short selling

This thrilling scenario is made possible by short selling, which refers to the strategic decision to borrow stocks from a broker and resell them on the market with the expectation that the price will decline. The investor then aims to buy back the shares at a lower price and return them to the broker, thus profiting from the difference in value.

Short selling can also entail opening a position by borrowing shares that the investor does not own and subsequently selling them to another investor. Shorting, or selling short, can also be described as a bearish stance on a stock or asset. This allows investors to reap profits from stocks or securities as their value plummets.

The perils of short selling

One of the most precarious risks associated with short selling is the looming threat of a short squeeze, which materializes when a sudden upsurge in a stock's price terrifies a considerable chunk of short sellers simultaneously. Faced with a price increase, these sellers rush to close their positions by buying back the stock en masse. Such a surge in buying activity could further boost the stock's price, exacerbating the losses of remaining short sellers. Consequently, a feedback loop ensues that pushes the price even higher, compounding short sellers' losses exponentially over time.

The motivation behind shorting

Investors may employ shorting as a speculative strategy, undertaking a high-risk maneuver that potentially yields substantial returns in exchange for embracing exceptional risk. While long-term investors rely on comprehensive analyses of a company's financials, management, and future prospects, speculators base their decisions on short-term price movements and market signals in pursuit of swift profits.

Shorting as a hedge

Shorting a stock can also serve as a hedging technique. For instance, if you own shares in a company but harbor doubts about its short-term performance while wishing to retain your holdings, you can choose to short the stock. By doing so, you can potentially offset losses from your long position by buying back the stock at a lower price if its value plunges.

The GameStop Short Squeeze

In January 2021, a historic short squeeze sent shockwaves through the financial world as the stock of American video game retailer GameStop (NYSE: GME) and other securities experienced a meteoric rise, resulting in profound implications for certain hedge funds and substantial losses for short sellers. The staggering twist of events unfolded against the backdrop of GameStop's public float witnessing an astonishing short interest of around 140%, fueling a frenzied rush to cover positions and drive the stock price even higher.

The origins of this extraordinary short squeeze can be traced primarily to users of the subreddit r/wallstreetbets, an influential community on the popular social news website Reddit. Their collective actions, combined with the participation of several hedge funds, triggered a chain reaction that rippled across global markets. The peak of this upheaval occurred on January 28, propelling GameStop's share price to dizzying heights of over US$500 per share in pre-market trading (split-adjusted), an astronomical surge from the modest valuation of US$17.25 at the beginning of the month. Notably, this unprecedented rally in GameStop's stock spilled over to other heavily shorted securities and even cryptocurrencies, amplifying the market frenzy.

However, the saga took an unexpected turn when certain brokerages, particularly app-based platforms like Robinhood, made the controversial decision to halt the buying of GameStop and other affected securities. Citing their inability to meet collateral requirements at clearing houses, this move drew widespread condemnation and ignited allegations of market manipulation from influential figures spanning the political spectrum. Robinhood subsequently faced a wave of class-action lawsuits, and the U.S. House Committee on Financial Services conducted a congressional hearing to investigate the incident.

Despite the peak of the short squeeze occurring in late January, the astonishing price levels and volatility persisted. On February 24, GameStop's stock price doubled within a remarkable 90-minute period before stabilizing around the US$200 mark for the following month. However, on March 24, the stock plummeted by 34% to US$120.34 per share after the company released its earnings report and announced plans for a new secondary stock offering. Remarkably, the very next day, the stock staged a remarkable recovery, surging by an impressive 53%.

The GameStop short squeeze will be remembered as a watershed moment, illustrating the power of retail investors rallying together and reshaping the dynamics of the financial markets. Its far-reaching implications continue to reverberate, prompting a broader examination of market practices and regulations in an era marked by democratized access to information and trading platforms.