If you’ve been watching the action in GameStop (GME) this year you’ve no doubt heard the words “short squeeze.”
And if you haven’t been following GameStop, you should, purely for the entertainment value. They might very well make a movie about the trading action in that stock over the past few weeks.
As I’m writing this in early February, GameStop – a struggling retail chain selling video games and accessories – is up roughly 2,300% in 2021 alone. That’s decades’ worth of strong returns in less than a month.
If a short squeeze can cause a move like that, it’s worth reviewing what exactly a short squeeze is. And to do that, we need to review what short selling is.
Short selling – or shorting – is placing a bet that a stock declines in value. To do this, you borrow shares from another investor and then sell them. (Your broker does this for you behind the scenes.)
But remember: Those shares aren’t yours to sell. You borrowed them. This means you are obligated to buy the shares back so you can return them to the original owner.
There is an old saying attributed to Daniel Drew, a legendary speculator of the late 1800s: “He who sells what isn’t his’n, must buy it back or go to pris’n.”
They don’t send bankrupt short sellers to prison anymore, but the obligation to buy the shares back is very real. And this is where short squeezes come into play.
Let’s say that a short trade has gotten crowded. You have a lot of short sellers, all of whom have borrowed shares and all of whom must eventually pay them back. This is a tinderbox just waiting for a match.
If something – anything – causes the stock to rise, it can quickly turn into a buying frenzy as the short sellers trip over one another to buy the shares so they can cut their losses and exit the trade.
The higher the stock price goes, the more short sellers are forced to cut their losses by buying back the shares they sold. And their frantic buying drives the price even higher, forcing more short sellers to follow their lead.
Panic-buying begets more panic-buying, egged on by speculators who know the situation the short sellers are in and actively try to put the screws to them. This is a short squeeze in action.
And it’s exactly what happened in the shares of GameStop.
Short selling is risky because it has limited upside, but unlimited downside.
If you short a stock at $10, it can’t go lower than zero, so you can’t make more than $10 per share on the trade. But there’s no ceiling on the stock. You can sell it at $10 and then be forced to buy it back at $20 … or $200 … or $2 million. There is no theoretical limit on how high a stock can go.
The first way to avoid getting squeezed is simply to avoid shorting. But if you do decide to short, make sure you keep your position sizes modest and try to cut your losses early if the trade goes the wrong way.
This article first appeared on February 11 at Kiplinger.com
Photo Credit: Nick Harris via Flickr Creative Commons
Disclosure: This piece is provided as educational information only and is not intended to provide investment or other advice. This material is not to be construed as a recommendation or solicitation to buy or sell any security, financial product, instrument, or to participate in any particular trading strategy.