EVERY SO OFTEN, an arcane topic jumps from obscurity into the headlines. Such was the case last week when everyone was suddenly talking about the “short squeeze” on Wall Street. Below I’ll explain what happened and offer four thoughts on how to respond.
What does it mean to short a stock? In simple terms, it means you’re betting a stock will decline in price.
How does one accomplish this? First, you borrow the stock from another investor who owns it. Then you sell it. But, of course, you’ll eventually need to return the stock to its original owner, so you’ll have to buy it back later. Since you’re betting that the price is going to drop, your hope is to pay less when you buy back the shares and then keep the difference. Suppose you sell a stock for $10. If you can buy it back later for $8, you’ve made a $2 profit.
How do you borrow a stock from another investor? The most common lenders are mutual funds, which lend out their holdings in exchange for “rental” fees. For some mutual funds, this rental income can be substantial. In fact, there have been cases in which an index fund has beaten its own index—a seemingly impossible feat. They can accomplish this, in part, by earning income from lending out their holdings. In 2019, Vanguard’s Total Stock Market Index Fund pulled in more than $150 million this way.
What is the risk in short-selling? In the example above, an investor borrows and sells a stock at $10, and later buys it back at $8, happily earning a profit of $2 when the price drops. But what if the price goes up instead? Then the short seller has a problem, because he or she still needs to buy the stock back to return it to its owner. The higher the stock goes, the bigger the problem is. Suppose the stock goes from $10 to $15. The short seller is looking at a loss of $5 per share. What if it goes to $25? The prospective loss grows to $15. And it could get far worse: Short sellers are exposed to potentially unlimited losses.
What is a short squeeze? When the price of a stock rises significantly, short sellers begin to panic. Recognizing they could be completely wiped out, short sellers scramble to buy back shares, so they can limit their losses. But this isn’t always easy. If a stock is widely shorted—known as a having a high “short interest”—there may not be enough shares available to buy back. This causes the panicked short seller to bid even more for the stock, hoping to capture shares at any price. This causes the price to go yet higher, inflicting further stress on other short sellers. The cycle intensifies as the price heads higher and higher.
What happened most recently? A group of investors on a message board called WallStreetBets started discussing stocks with high levels of short interest, including money-losing video game retailer GameStop. It’s difficult to say how many investors it took to initiate the squeeze on GameStop, but aggregate trading volume paints a picture.
Most days, fewer than 10 million shares change hands. But last week it grew to nearly 200 million shares. Along the way, GameStop’s share price rose geometrically. A few weeks ago, it was trading under $20 a share, but on Monday of last week it topped $75. On Tuesday, it nearly doubled to $148. On Wednesday, it was close to $350. On Thursday, it topped $450 in pre-market trading before dropping back. On Friday morning, it nearly doubled again in the first 15 minutes of trading and ended the regular trading day around $325.
How bad did the short squeeze become? It’s hard to quantify the losses. But what’s known is that two hedge funds threw in the towel on their short bets. At least one fund, Melvin Capital, was forced to accept a multi-billion-dollar lifeline and had to deny rumors it was headed for bankruptcy.
What happened from there? Almost immediately, opinions came in from all sides. One government regulator called for a 30-day trading moratorium on GameStop shares. But on Thursday, when the broker Robinhood implemented a ban on purchasing GameStop and other similarly targeted stocks—a ban that I thought made good sense—it was met with vitriol from those who viewed it as an attack on the rights of small investors. Late in the week, a class-action lawsuit was filed against this broker. Many politicians called on the SEC to investigate.
Why did this happen now? It’s usually hard to pinpoint the origin of a mania. In a lot of ways, the past week’s frenzy is just a continuation of what we saw last year, with a booming stock market fed by the advent of zero-commission trading, internet personalities who say “stocks always go up” and millions of people with more free time working from home.
But in this case, it’s possible to trace the origins. Since 2019, members of the WallStreetBets message board have been discussing GameStop. About three months ago, one member of the WallStreetBets message board put together a video in which he outlined the exact scenario that played out with GameStop.
How should you as an individual investor respond to all this? These are my recommendations:
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.