The Short Squeeze – An Old Game with New Players

For those who just want to skip to the end: For the stocks that have recently surged due to short squeezes, the likely ending is a 50-90% drop in prices from where they trade today, back to levels that are rational for longterm investment purposes. Whether or not one can be nimble enough to trade for a profit before that collapse occurs, we can’t predict, but we consider such an attempt as a form of gambling, not investing. You should not be surprised that we don’t endorse gambling, though we of course understand that many people engage in various forms of it. So our only recommendation here would be the same: Don’t risk any money you can’t afford to lose.

For everyone else, read on! 

Much of the country, and even beyond, is abuzz with the story of a number of short squeezes in the stock market over the past two weeks. Starting with Gamestop and then branching out to a variety of other names, momentum built up from online discussion forums caused some stocks to rise dramatically in price in an effort to “squeeze the shorts.” 

The basic idea here is that when a stock has a large short position (i.e., lots of investors are betting that the stock price will fall), those betting against the stock are at considerable risk if the stock price unexpectedly rises, as they may be forced to buy back shares at much higher prices. Since the potential losses of a short position are theoretically unlimited, a short squeeze can cause massive losses to an overall portfolio even if the position size started out small. 

While it is not common to have such large moves in a short period, short squeezes are not a new phenomenon on Wall Street, having been around since at least the 1860s. Most large short squeezes over time were triggered by a “corner,” an effort by an individual, a company, or a small coordinated group to buy up control of a stock (or a commodity) to a sufficient degree that short sellers would have no choice but to buy back shares from the controlling group at an inflated price. 

In 2021, the story is certainly novel. Instead of a small group with vast sums of money to create a corner, a massive group of loosely-coordinated individuals helped propel a rise in share prices on selected stocks in order to force a short squeeze. As of now, it may appear like these short squeezes are pure success for those who have bought shares, but the story is not yet over. You might be surprised to learn that while a short squeeze is obviously bad for those who had the short positions, it has often led to financial ruin for those who initiated the corner in the first place! 

You see, in order to corner a stock and force a short squeeze, you have to buy a massive amount of shares at ever higher prices first. Eventually, you are able to sell some of your stock at tidy profits to the short sellers who need to buy back shares, but after that squeeze has run out, you will likely still be left holding a considerable amount of shares at prices that do not make economic sense for anyone else to buy. So naturally, the share price collapses and the originator of the corner finds himself stuck with a huge position that can only be sold at lower and lower prices. 

We expect a similar ending to the short squeezes occurring now, with an eventual 50-90% plunge back to prices similar to where they traded just a few weeks ago. The difference compared to traditional corners is that since ownership of the shares is widely dispersed, the fate of any particular trader is unknown. Some who hold the stock for short periods may certainly come away with large profits, but at some unknowable point in the future, the squeeze will be exhausted and every outstanding share of these stocks has to be owned by someone on the way down. If it’s not obvious, you don’t want to be one of those “someones.”