What’s happening with hedge funds and short squeezes?

February 2021 | Victoria Bogner, CFP®, CFA, AIF®

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Over the past two weeks, a few choice stocks have been in the headlines due to investors on a website called reddit banding together and bidding up the price to astronomical levels.  I can’t mention the stocks by name because of compliance, but I’m pretty sure you know what I’m talking about.

What exactly is going on here?  Has it ever happened before?  And what kind of implications does it have on the stock market at large?

To explain what’s happening, I first need to define a few terms.  Let’s talk about “shorting a stock.”

If you believe a company is going to crater in price, you can profit from its misfortune by selling stock in the company that you don’t actually own.  This is called “shorting” and you can do it by borrowing the stock from your brokerage of choice, then selling the stock back to the brokerage and pocketing the proceeds from the sale.  Now you have cash in your brokerage account and are “short” the stock of this company you think is going belly-up.

As long as you’re right and the stock’s price goes down, you can buy the stock back at a lower price, give the shares back to the brokerage, and pocket the difference.  But if the stock’s price goes up, then you might experience a “short squeeze.”

To illustrate this, let’s say you think the fictional company Acme Phonebooks is going the way of the dodo and you want to profit from their demise.  Their stock is trading for $10/share.  You open up a brokerage account with margin (meaning you can borrow money or stocks from the brokerage for a fee), put in $10,000 of your own money, and then borrow $10,000 worth of Acme stock.  That works out to 1,000 shares.  You sell the borrowed shares back to the brokerage and they give you $10,000.  You now have $20,000 in cash in your brokerage account and owe the brokerage 1,000 shares of Acme.

A little while later, If Acme plummets and the share price is now $1/share, you’re a happy camper.  You buy 1,000 shares of Acme for $1,000, give those 1,000 shares back to the brokerage, and keep your $9,000 of profit.

However, if Acme’s share price climbs and is now $20/share, you’re in trouble.  Instead of owing $10,000 worth of Acme stock to your brokerage, you owe $20,000.  And what’s worse, your brokerage is calling you saying that you either need to put more money in your account as collateral for what you owe or you need to give them back some of their Acme shares.  Well nuts.  Now what do you do?

If you have extra money laying around, you could put more in your brokerage so that they stop banging on your door.  But if Acme keeps going up in price, you’ll eventually run out of money to deposit.  At that point, you’ll be forced to buy some Acme stock at the higher price to decrease how much you owe to the brokerage.  That’s a short squeeze.  Investors are forced to buy shares of a stock that they’ve shorted to meet margin calls, but the increased buying moves the share price higher, which creates new margin calls and forces shorted investors to buy more shares, which moves the share prices higher, which creates new margin calls…you get the idea.

With a stock that has all or even more than all of its stock sold short (yes, it’s possible to sell a share of stock twice, but more on that another day), that means a ton of money has bet against that stock.  If the price begins to rise, millions of dollars are forced to buy to meet margin calls, and when we’re talking about the kind of money that hedge funds dabble in, you can see how this short squeeze cycle would cause the price of a stock to skyrocket.

That’s exactly what happened.  Stocks that had over 100% of their shares shorted were targeted by a huge number of average retail investors organized by a reddit thread.  The only entities that have the capital to hold an entire stock short are hedge funds.  These retail investors (legally) coordinated their efforts to buy as much of these stocks as possible in the hope of creating a short squeeze.  And after hanging on by their fingernails as long as possible and opening up extra lines of credit to meet margin calls, they couldn’t hold out forever.  Eventually, those hedge funds were forced to buy back the stock they had sold short to meet margin requirements, and the short squeeze began.  As a result, these stock’s prices soared.

To put this in perspective, one of these stocks was shorted by hedge funds at $4/share.  At the peak, one was trading for $475/share!  That means that at that peak price, if a hedge fund held $10 million of the stock short at $4/share, they would have lost close to $1.2 BILLION on their $10 million bet.  Ouch.

Sidenote: I do not recommend short selling.  I also don’t recommend trying any get-rich-quick schemes by participating in this kind of highly speculative trading.  Your time is better spent at the golf course than trying to catch the tail of a shooting star before it becomes a meteor crashing back to earth.

Has this happened before?  Yes, many times in fact.  The first recorded incident has to do with tulip bulbs in Europe.  Dubbed “tulip mania,” tulip bulbs and contracts to buy tulips were selling for as much as an artisan would make in 10 years!  Then the bubonic plague hit and the price of tulip bulbs plummeted.  Many who made bets on getting rich quick on tulips lost everything.

What kind of implications does this behavior have on the market at large?  Honestly outside of this small pocket of targeted stocks, not a lot.  While it makes for interesting reading, this doesn’t affect the broad market.  It may result in some tighter regulations around margin accounts, short selling, or other details surrounding these phenomena, but again, that wouldn’t affect the market as a whole.

It’s fascinating to watch, entertaining to read about, but I strongly recommend against playing the game unless you’re willing to lose nearly all of your investment.  In my opinion, it isn’t investing so much as gambling.  It’s better to stick to a solid investment strategy based on objective fundamentals and not speculation.

 

 

Disclaimers and Notes
The views are those of Victoria Bogner and should not be construed as investment advice.  All information is believed to be from reliable sources, however, we make no representation as to its completeness or accuracy.  All economic and performance information is historical and not indicative of future results. 

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