The Short Squeeze Heard ‘Round the World

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During the last week of January, the price of the GameStop Corporation stock increased from $20/share to nearly $350/share. The GameStop business model was thought to be in trouble as video game purchases moved online. According to the data collection company, Statista, about 83% of video game purchases are currently made online, compared to 20% in 2009.

A company in trouble becomes a target for short-sellers. “Short-selling” involves borrowing a stock you do not own, selling it, and then buying it back in the future. If the price falls during that time, you earn a profit. In contrast, “going long” on a stock means you buy it, hold it, and hope the price rises.

With short-selling, losses can quickly accumulate if the stock price rises rather than falling. Going long on a stock limits the potential loss to the amount of the initial investment. If you buy $100 in a company’s stock, the most you can lose is $100 if the stock’s price falls to zero. In contrast, there is no limit to the losses from shorting a stock, since there is no limit to how high a stock’s price can potentially rise. Losses to hedge funds who shorted GameStop stock in January are estimated to be in the billions of dollars.

When word of a large short position becomes known, other investors can execute a short squeeze, which means they buy the stock to cause its price to rise. If short-sellers decide to cut their losses and buy the stock to close-out their short positions, this will cause the stock’s price to rise even further – hence, the “squeeze.”

A way to further squeeze the short-sellers is to execute a “gamma squeeze” by buying out-of-the-money call options on the stock. A call option gives the holder the option to buy the stock at a particular price, called the “strike price.” Out-of-the-money means the strike price is higher than the stock’s current price. Since it is unlikely such an option will be executed, the price of the option is low. If investors buy enough of these cheap options, the entity issuing them will buy the stock just in case the option does end up being exercised. This will cause the stock’s price to rise, hence the squeeze.

This squeeze was orchestrated by anonymous posters on a Reddit message board called “Wall Street Bets.” A motivation for many posters was to stick it to the hedge funds as much as it was to profit. Anger from the Wall Street bailouts during the last recession while Main Street Americans lost their jobs and homes continues to fester. This anger has compounded during the COVID shutdowns as it again appears that some people are exempt from the rules everyone else has to follow. California’s governor dining indoors at a fancy restaurant is an infamous example. Having two sets of rules, where some people incur huge costs while others pay none, is not sustainable.

 

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