Game Stop, and Other Short Squeezes in the News
by Caitlin Combest on Feb 1, 2021
A big short squeeze involving Game Stop, Hedge Funds, and Robin Hood has made recent headlines that you probably have seen. While this has been a pretty extreme event, it is not unprecedented. It has happened many times in the past and will probably happen many more in the future. To understand what is happening, it will be useful to review a few terms that apply to stock market investing.
There are two basic types of analysis that people do to evaluate their potential risks and rewards before buying a stock. They are Fundamental Analysis and Technical Analysis. Fundamental analysis is the evaluation of the business issues related to the company whose stock is being considered. Fundamental analysis looks at things like, 1) the company’s products and/or services, 2) the market for the company’s products and/or services, 3) the company’s financial strength including profitability and growth, 4) the strength of the company’s management team, 5) the strength of the company’s competitors, and as many others as are relevant. Fundamental analysis is used by long-term investors to try to identify good companies that will increase in value over long periods of time due to the success of their business. The risks involved are mostly due to the uncertainty of the estimates for future company and overall economic performance. This is the method that I use when deciding on stocks to recommend to my clientele and to hold in their accounts.
Technical analysis has nothing to do with the business activity of the stock being analyzed. It is an evaluation of the supply and demand characteristics of the stock itself. Like any other commodity, when demand for a stock exceeds supply the price will go up. When demand for the same stock drops below the supply in the market, the price will drop. There are many sophisticated tools, techniques, and theories to help technical analysts try to predict future supply and demand changes in a stock. Sometimes these techniques can lead to the identification of supply and/or demand anomalies that have no relationship to the value of the business whose stock is being traded. It is the attempt to discover these short-term anomalies that is the objective of technical analysis. When the analysis is correct, the trader can earn a short-term profit when the anomaly is corrected. Trading on these anomalies is, by its nature, risky and speculative. When these anomalies become so large that there is no correlation to the value of the business of the stock being traded, it is even more risky. When the disconnect becomes too large, there can be lots of other factors that can contribute to make the market even more unstable, unpredictable, and risky.
Let me walk you through a hypothetical example of such a scenario to try to simplify what has happened:
First, a hedge fund or other large, (typically institutional) investor does some research (fundamental and technical analysis) and identifies a company that they think has a market stock price that is above what they believe the company is worth. They may find something that they believe is flawed with the company’s business, (fundamental analysis) that could lead to the company’s failure. If the company fails and goes out of business their stock would become worthless. The large investor goes to their stock broker and borrows one share of the company’s stock, (that the broker holds for other customers) and sells the share at market price, (which the investor believes is incorrect). This is called opening a short position or a short sale. Now the large investor has the money from the sale of the stock, let’s say $100 in our example and waits and hopes that the rest of the market realizes that the company is no good and the stock price goes down. So, the large investor has the $100 and he owes his broker one share of company stock. If the large investor is correct and the company fails, he may buy back the stock in the market for, let’s say $1. He gives his broker back the share that he borrowed and keeps $99 profit. That is called closing his short position. If, however the large investor is wrong and the company does well, the company’s stock could go up in value. At some point the large investor will be forced to buy the stock back at a price higher than he sold the borrowed share for. Let’s say the stock goes up to $200. The large investor must pay $200 to purchase the stock to repay his broker for the stock he sold for $100. The large investor will suffer a $100 loss to close his short position. Selling a share of stock short is generally considered a more risky act than just buying a share of stock. This is because when you buy a share of stock your potential loss is limited to the price you paid for the stock. However, if you sell short your loss is unlimited because there is not an upper limit to how high the stock price might go. To protect themselves from absorbing the potential losses of their client’s, brokers will require their client’s keep a certain percentage of cash or other equity in their accounts to cover this potential loss. This is called the brokers margin requirement.
This typical short sale transaction is normal and happens every day in the stock market. Not really anything to intriguing here.
But, when you start adding some unsavory human characteristics like greed, deceit, and various other factors… things like the recent events in the news can happen. First, if the large investor has lots of money and doesn’t mind taking advantage of the power that their financial strength gives them at the expense of someone else he can attempt to sell so many borrowed shares that he actually drives the stock price down in the market by changing the supply and demand curve. That is he sells so many borrowed shares that the supply of the shares in the market exceeds the demand, resulting in a drop in price. He can create the perception that the stock is overvalued just because of the drop in price that he is able to create by flooding the market with borrowed shares. This is a form of market manipulation by changing the supply and demand curve that drives technical analysis. If several people get together and pool their money to impact the supply and demand characteristics of a stock in order to profit from the price movements, it is an illegal conspiracy.
Well, what could go wrong here? What if, despite the efforts of the short seller, the stock price goes up? The short seller, in order to limit his loses could be forced to buy the stock at a higher price to close his short position. By doing this, he is adding to the demand for the stock price and it will go up even more. This is called a short squeeze. If he has borrowed money from his broker to maintain his short position, the broker may demand that he pay back the money. This will force him to sell even more stock, causing the stock to go even higher, making the squeeze even tighter. What if a bunch of people get together on .. say some social media platform and decide to pool their money to buy the stock, causing it to go even higher, causing the short seller to buy even more stock causing prices to go even higher… and on…. and on.. get the picture? By focusing only on the technical analysis of supply/demand of the stock in the market, and successfully manipulating that relationship…the stock price can be driven up so high that it is many times higher than the fundamental analysis of the company would indicate.
Well, what could go wrong now? Eventually, all of the short positions will be forced to be closed, eliminating one big source of demand…causing the stock price to fall. Then you could have brokers forced to limit purchases to protect themselves from the financial risks the inflated stock price poses to their financial security. It is beyond the scope of the discussion of this article, but the brokers really don’t care who wins or loses. Their limits will result in another reduction in demand causing the stock price to fall even more. Then, the people that bought in late because of the rising prices see the loss of their money so they start to sell, causing the stock price to fall even more… and on… and on.. get the picture?
In summary, the speculative game that has resulted in the short squeeze(es) currently in the news is a rough and tumble game where people can make AND lose lots of money. Both sides of this trade are trying to manipulate the market to their advantage. But, much like a pyramid scheme, for there to be one big winner there has to be lots of big losers. Typically, the winner goes to the bank and the losers cry foul! It is a zero sum game. I don’t play it and I don’t recommend my clientele play it. If I happen to see one of the stocks that we own get caught up in it, then I consider it similar to winning the lottery. The stock will be driven up way higher than its real value. The only decision is when to decide that enough is enough and get our money out of it. The rest is just an interesting story to follow on the news.
Joe Combest, CFP®