Investing Basics

Understanding Short Selling & Short Squeezes in the Stock Market

by Max Kirouac
April 3, 2021
CFA® – Investment Counsellor, BMO Private Banking
April 3, 2021

Summary: Short Selling & Short Squeezes

For the first time in years, Blackberry, Nokia, and AMC are in the news. Trading activity has brought a number of once-great monoliths back from the grave, none more so than GameStop – the brick and mortar video game retailer, which traded as low as $3.94 in late July 2020, hit an all-time high of $483 on January 28, 2021 amidst a frenzy of retail trading. This seems to be a good of time as any to discuss the concepts of short selling and short squeezes. If you need a refresher or are starting from scratch on understanding the basics of investing, click here for more helpful articles from your peers.

Theorizing about these price movements has become a favourite pastime amongst market enthusiasts. Some believe it stems from the democratization of stock market participation through zero/low-commission trading platforms. Others take a more ideological view and believe that the retail masses have found a way to get back at hedge fund managers who have horded the gains wrought by the stock market. I personally don’t think this price action is reflective of a revolution. Rather, I believe the motivation is an opportunity to make a quick buck – plain and simple. Greed has long been a powerful motivator. Regardless of the cause, the sophistication of this trading activity is impressive and derives from an intimate understanding of short selling and short squeezes (including the concept of short interest).

What is Short Selling? 

The stock market differs from most other marketplaces in that you’re able to sell something you don’t actually own. Traders use short selling when they believe a stock’s price is likely to decline, allowing them to profit if the price goes down. The process involves borrowing shares from a shareholder, selling them at their current price and then buying them back (hopefully at a reduced price) to close out the position. In a frictionless world, the difference between the price you sold the shares at and the price at which you bought them back represents your profit or loss. In practice, there are carrying costs involved in selling shares short (for example, you must pay any missed dividends or distributions to the individual who lent you the shares to sell). In addition, since you are being “loaned” shares, there is interest involved. When many investors are short on a stock, this interest can run at 20-30% annually to reflect the high demand for shares to sell short. Further, while buying a stock limits your downside to the price you paid, the loss potential with short selling is theoretically limitless as stock prices don’t have a maximum value. Given the risk and costs involved, short selling should be reserved for high conviction trades only. 

This is where GameStop enters the story. GameStop’s retail model feels archaic given current digital delivery capacity – why should I go to a brick and mortar retailer to buy video games when they can be purchased directly through game systems from my couch? The shift to digital delivery is reminiscent of the rise of Netflix leaving Blockbuster on the scrap heap. Institutional investors saw the writing on the wall for GameStop and started short selling the stock in huge quantities, hoping to profit from its (presumed) inevitable decline. 

What Does Short Interest Mean? 

Short interest refers to the percentage of a company’s total freely traded shares that are sold short. For simplicity’s sake, assume that a company has 10 shares that are traded on the public exchange. If 2 shares are sold short, then short interest is 20%. With GameStop, short interest got as high as 140% (you read that right – 140%). 

Short interest is a metric that can be readily tracked; some curious (and increasingly sophisticated) Reddit stock speculators took note of the short interest on positions like GameStop and proceeded to rally the online retail trading network to buy shares of GameStop and initiate a short squeeze. 

What is a Short Squeeze? 

To reiterate, short sellers profit if the stock price goes down. A short squeeze begins when a wave of buy orders for a certain stock pushes the price up. The individuals that have sold the shares short are now faced with a dilemma: their initial trade has moved against them, so they now have to wait and hope shares fall, or buy shares on the exchange to “close out” their short positions and limit their losses. Many short sellers choose to do the latter and, by buying the stock, they push the price even higher. Remaining short sellers are faced with growing pressure to close out their positions, so the stock price continues to climb in response to additional buys. Options trading is beyond the scope of this piece, but it also played a role in the meteoric climb in stock price for GameStop and other retail favourites. The short squeeze, coupled with a wave of retail investors who were afraid of missing out on the potential gains, caused GameStop stock to jump from $42.59 on January 22, 2021 to $96.73 on January 25, 2021 to $354.83 on January 27, 2021, before reaching a high of $483 on January 28, 2021.  

Let’s illustrate this further with an example. Say a trader decided to short 1,000 shares of GameStop when the share price was $42.59. As discussed, the gain or loss on a short sale is the price at which the shares were shorted minus the price at which they were bought back. If the trader saw the stock hit $483 a share and decided to finally stop the bleeding, their loss on the position would have been over $440,000. This highlights the asymmetric risk of shorting shares: the maximum gain possible for this short sale would have been $42,590, if GameStop shares went to $0. The maximum loss is theoretically boundless. 

In this case, Reddit provided a captive audience that could be mobilized by a few savvy traders who noticed an exploitable market dislocation. The fallout has been extreme – certain hedge funds lost billions and the integrity of stock exchanges was brought into question as some platforms halted trading. Suffice it to say that the strangeness of 2020 has carried on in 2021, with a failing video game retailer bringing short selling and short squeezes into the public lexicon.  

Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.

About Max Kirouac

Max Kirouac, CFA®, is an Investment Counsellor at BMO Private Banking in Winnipeg, Manitoba. If you would like to discuss this article more with Max, connect with him on LinkedIn.

You may also like

Which Investment Platform is Right for Me? Wealthsimple or Interactive Brokers?

In our last article, we compared two of Canada’s leading low-cost investment platforms: Wealthsimple Trade and Questrade. In this article, we are going to consider another low-cost option that is lesser known north of the border: Interactive Brokers Canada.

Understanding the Basics of Portfolio Rebalancing

Rebalancing is the act of periodically reviewing the asset allocation in your portfolio and, if the balance is “off” from your original intention, then investments are reallocated to ensure your portfolio is restored to your original goal...

Subscribe to Modern Money

Enter your e-mail to receive updates on new articles from Modern Money, the ultimate guide for young professionals.

Don't worry, we won't send you any spam.
Share via
Copy link
Powered by Social Snap