Whether you follow the market or not, by now, there’s a good chance you’ve heard of what’s been happening with the video game retailer, GameStop (GME). The internet and stock market are aflamed over GME over the past few weeks -- the meteoric rise in the price of GME has left many investors in awe.

 

 

The unprecedented rally is a result of an army of individual investors wielding growing influence across the globe on Reddit to push up GME’s stock price. And as the prices jumped, it forced short sellers in the stock to go for a “short squeeze”, leading to the surge in share prices. 

 

What is short selling? *source: Investopedia

 

Short selling is an investment strategy that speculates on the decline in a stock price. Short selling occurs when an investor borrows shares of a stock, believing that it’ll decline in price by a set future day (the expiration date); then sells these borrowed shares on the open market. 

 

Before the expiration date, the short seller is betting that the share price will continue to go down and they can purchase them at a lower cost.

 

Short selling has a high risk, high reward ratio: if short sellers are right, then they pocket the difference between the price when they initiated the short and the actual sale price. However, they can lose big if the stock’s price rises.

 

*source: DailyFX

 

What is a short squeeze? *source: Investopedia

 

Essentially, a short squeeze means short sellers are being squeezed out of their positions, usually at a loss.

 

If someone tries to push up the price by buying lots of shares, even when the company isn’t doing exceptionally well -- that is the squeeze. 

 

A short squeeze forces short sellers to close their short position: buy up the shares they owe their brokers and return them before the expiration date to forestall greater losses. 

 

This, however, only adds to the upward pressure of the stock’s price and ticks up demand in the market -- every buying traction by a short-seller sends the stock’s price higher, forcing another short-seller to buy. This cycle ultimately continues as short-sellers struggle to cover their positions. 

 

This has happened before: Volkswagen Edition *source: Seeking Alpha 

 

In the middle of the financial crisis, many automakers were viewed as bankruptcy risks -- a rather lucrative time to be a short seller as there was a higher than normal short interest (~15%) in Volkswagen. 

 

Knowing Volkswagen’s available float was much lower than most realised, Porsche (which owned a ~30% stake in Volkswagen at the time) started buying enough call options to give it an effective 74.1% stake in the entity, just 0.9% below the level where financials would be consolidated. They then announced to the world, on a Sunday, its intention to "raise this target to 75% in 2009 as long as economic conditions permit."

 

This set off an incredible squeeze in which Porsche made ~$10 billion and hedge funds lost $30 billion. This even briefly vaulted Volkswagen to become the most valuable company in the world. 

 

 

 

 

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