March 4, 2021
Source: Winnipeg Free Press
By: Joe Schlesinger
A whole lot of words have been on everyone’s lips lately that likely weren’t a just few weeks ago — like “short squeeze” and “GameStop” among other related terms.
It’s safe to say at the start of 2021, not many people knew what short selling was, much less a short squeeze. And you probably hadn’t passed by a GameStop outlet — purveyor of video games — given the state of the world.
Yet both are now familiar for good, bad and downright ugly reasons, thanks to a Reddit subgroup called WallStreetBets.
Its members, along with other investors, banded together to push GameStop’s price to the moon — to use their vernacular.
The most salacious parts made headlines outside business news: an unloved stock — facing dimming business prospects — soared to about US$347, an increase of about 1,600 per cent. Driven by no-fee, no-commission trading platforms — chiefly Robinhood — the little investor was able bid up its price, and figuratively kneed Wall Street hedge funds in their wealthy family jewels.
Still, maybe you have a few questions, like just what exactly is a short squeeze anyway?
Here’s a backgrounder courtesy of professional portfolio managers shedding light on one of the darker corners of the market.
What’s short selling?
Often used by large investors — i.e. hedge funds — to bet against companies with gloomy outlooks, short selling involves borrowing shares often from a brokerage, which in turn earns interest for the “loan.” The borrowers then sell the shares and hope the price falls. If it does, they buy back the shares and return them to the broker. They profit from the difference between selling the shares at a higher price and buying them back at a lower price, says Jeff Ryall, associate portfolio manager with Cardinal Capital Management in Winnipeg. “The maximum upside for the short position is if the stock goes to zero in price, which is unlikely.” While it can be very profitable, short selling also is extremely risky because the downside is unlimited. The reason being a share price has no ceiling, he adds.
Risks aside, short selling is a “perfectly legitimate” strategy and goes on all the time, says Hardev Bains, president of Lionridge Capital Management in Winnipeg. “But there are some players who abuse it by engaging in market manipulation.” This perception fuels dislike of hedge funds. A sore spot for many investors is hedge funds often publish and promote research why they think a company is in trouble. And GameStop had a lot of hedge funds doing research and in turn shorting it. In fact, by mid-January the number of short positions out-numbered GameStop shares available for trading.
Putting on the squeeze
A short goes wrong because the price of the underlying stock increases. When that happens the owner of the shares can make the borrower buy back the stock and return it. Ryall says in most cases short sellers might have to close out a position within the next trading day. But because GameStop’s share price was rising so rapidly, the hedge funds shorting it were forced to close out their positions more quickly. That further pushed the stock’s price up because of more demand than supply of stock.
Chief investment officer Craig Basinger at Richardson Wealth in Toronto notes hedge funds often try to squeeze other hedge funds with short positions. GameStop’s squeeze was unique because retail investors came together to do it. Yet he argues the squeeze was possible not only because of no-commission, no-minimum trading. It worked well because GameStop stock was so heavily shorted and otherwise lightly traded. So when investor demand for its shares grew quickly, this led to big price jumps because the supply of available shares was relatively low. “You put all these together and you can see how a big influx of new investors into one company can have a material impact,” he says.
The big stonk!
As the squeeze unfolded in late January, Tesla CEO Elon Musk — no fan of hedge funds — tweeted “Gamestonk!,” bringing yet another trading subculture term into the mainstream. A misspelling of ‘stock’ — often appearing in memes about bad money mistakes — it’s revered by groups like WallStreetBets who crudely embrace making stupid trades as much as profitable ones. Indeed stonk also refers to a trade gone wrong — a real stinker (hence Gamestonk). Another meaning is an artillery barrage. And that really describes the effect on hedge fund short positions as millions of investors bought GameStop shares. Yet many of those investors soon felt the stonk, too, when Robinhood and other brokerages halted purchases of GameStop, ending the squeeze.
Now the U.S. Congress aims to investigate why trading was halted, and hedge funds’ practices. No one knows for sure why trading was halted, but some believe hedge funds — and big money backing them — forced brokerages to limit trading. In contrast, Robinhood stated it had to raise more capital to keep up with demand. Others speculate regulators worried about systematic risk at a time when the economy was already in disrepair. Brokerages have since removed limits on GameStock and other companies WallStreetBets wants to send to the moon.
But their strategy has yet to blast off like it did (though never say never).
What is more certain is small investors who bought GameStop near its peak are also feeling the stonk.
“This started out as a new-aged, crowdsourced approach exploiting a market inefficiency,” Basinger says.
But in the end, it morphed into something more familiar: a greed-fuelled bubble.
“When you boil it all down it’s just pure gambling.”