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How Did the Short Squeezing Phenomenon Disrupt Wall Street Businesses Recently?

Jan 28, 2021 6:01 AM 5 min read

The story of David and Goliath is not the first parallel one would think of when it comes to Wall Street. 

As the Goldman Sachs sales rep says to Michael Burry in The Big Short, “This is Wall Street, Dr. Burry. If you offer us free money, we ARE going to take it…”

Yes, in most cases that is true. Institutions and smart money usually trump over the “retail” guys when it comes to the financial markets. But David did show up recently. 

And so did an army of online retail traders. Their slings and stones got replaced by digital tools like social media and electronic trading platforms; and the hole in Goliath's armour was the eagerness of hedge funds to make quick money. 

But enough of these biblical references. Let's take you through the events circling about the last one month which has thrown Wall Street money-making mechanics in a frenzy.

What Happened? 

At the centre of this episode lies a company called GameStop (GME), a mall-based video game retail company. It was a fledgling enterprise earlier but with evolution in gaming tech and the newly-imposed lockdowns and closure of stores, business was fading. Debts mounted as high as $450m in Q4 2020 and sales contracted by 40% in the preceding two years. 

In April 2020, the GME shares were reading at $2-$4. Analysts had compared its fate to the likes of J.C. Penney and Blockbuster Video, popular businesses which got swamped by technological change. 

But, this presented traders (particularly the ones from a hedge fund called Melvin Capital Management) with an opportunity to short GME shares.


Quick Primer on Short-Selling 

It refers to the ‘darker’ trading strategy of selling high and buying low (yes in that order). In part one, the short sellers sell high by borrowing stock from shareholders. In part two, they buy low by picking up shares at a lower price, returning them to the lenders, and pocketing the difference. 

So, for this strategy to work, the shares must go down in price. That is the underlying bet placed by the short sellers. Therefore, the most suitable targets for short sellers are companies whose financials are in imminent decline (like GME) and have minimal prospects of recovery. Sometimes, it is also companies who have flawed business models or have become beacons of fraud (like Enron) or the company being overvalued (like Tesla, which, short sellers have time and again alleged, has been making money not by selling cars but by trading auto emission credits). 

Following the same strategy, Melvin Capital amassed as much as a $55m short position against GME. Andrew Left, a prominent short seller, predicted GME's stock to plunge to $20 from its existing $40-value on January 21st 2020.


The Prophecy Disproved, In Theory 

Enter WallStreetBets, a Reddit forum, whose members discovered Melvin's massive short position against GME which was disclosed amongst the latter's listed put options (as is mandatorily required as per SEC guidelines). They also found other stocks which Melvin was hedging against (iRobot, Nat. Beverage and Bed, Bath and Beyond). 

Members of this forum and other users thus began a massive campaign to try and debunk these positions by pouring money into GME's shares and pushing its price up. Since January 11th 2021, GME shares have spiked more than 500%. At the same time, it has left short sellers with losses to the tune of $5bn, making it one of the biggest short squeezes in history so far.


What is a Short Squeeze? 

To define in simple terms, short squeezings occur when the value of a stock or underlying asset suddenly increases. It is triggered by events like a renewed and positive growth forecast, or others, ultimately forcing traders who sold it short to buy it back. 

There are three things to note here. 

One, the short sellers incur far greater losses. Why? Because, the sellers leverage their bets with borrowed money (from shareholders who lent them their stock). So, if they don't secure a substantial difference (interest costs plus margin included) before their positions have expired, they have to pay shareholders out of their own pocket. 

Two, profits in short selling are capped but potential losses are infinite. If you short a stock at $10, your potential gain is $10, if its price goes to zero (as GME short sellers had bet). But if the share prices keep rising, your potential losses are unlimited because you don't know how far the price may rise and thus how far you have to bail the shareholders out. 

Three. If the share prices are driven up, the stock value pulls higher and eventually it surpasses the capacity of the shorts to remain short. So, it works in the same counterintuitive fashion as the proverbial boat with a leak at the bottom. Short sellers try to bail out by covering (or buying) at a high share price (much to their disappointment) and swallowing their losses, while this buying activity consequently pushes the stock even higher and forces more shorts to cover until ALL the short sellers are swept out! 

That's what happened with GME and Melvin. Short sellers have reportedly gathered a mark-to-market loss of more than $6bn year-to-date in the stock. On the other hand, the retail investors who propelled this market charge with a buying frenzy have gained big (some users earning almost over a 1000% return).

Source: Google Finance


Is That Good or Bad? 

As is clear, it was good for the retail investors. Bad for the short sellers. And as it would seem, ugly so far for Melvin Capital. 

Short selling, per se, isn't illegal. It is, in fact, an essential instrument of correcting market inefficiencies. They counter raging bullish tendencies of corporate managements who thrive upon the untouched nirvana of investor optimism. Short selling helps break this corporate veil by sounding early alarms on potential mismanagement or frauds. 

On the other hand, what the retail investors did is also a classic example of stock 'manipulation'. But it is legal since the users are protected by the First Amendment to the US Constitution that guarantees freedom of speech on online social media forums like Reddit. (Not a conspiracy or mob-mentality, relax!) 

It was, however, one of the biggest short selling upsets to have happened in recent years causing $6bn in losses to a company that was valued at only $1.2bn two weeks ago. The two million-large crowd of self-proclaimed "degenerates" on WallStreetBets drove GME to the moon by trading across hundreds of thousands of Robinhood accounts. 


Where Does It Go From Here? 

As much rejoice as the citizen socialists managed to revel in, it isn't expected to last longer since market reinforcements for Melvin have started to reign in. A coalition of billionaire investors have swooped in with close to a $2.75bn worth investment in Melvin Capital in exchange for non-controlling revenue shares. 

It is, however, too soon (and risky) to predict the next course of market behaviour that in itself was an upset. It would suffice to say though that the people who make the most money on Wall Street were once defined by Jordan Belfort as the ones who were "drunk on youth, fuelled by greed and higher than kites". 

Can't say for sure which group qualifies more appropriately into this definition in light of the present context - the short sellers or the investors affiliated to WallStreetBets!


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