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Volatile price moves in beaten-down stocks like GameStop (GME) and AMC (AMC) are grabbing national attention and introducing a bevy of wonky trading terms into the popular lexicon. Discussions in Reddit forums, such as Wall Street Bets, are now dinner table fodder. And it all started last week with surging prices in a basket of stocks — a classic “short squeeze.”
Supply and demand
The modern stock market — an intricate web of interconnected exchanges where buyers and sellers meet — is at its heart simply a collection of auction markets. Price moves are explained by supply and demand.
Companies issue shares to investors and employees, which may be held or traded. The so-called “shares outstanding” (about 70 million for GameStop) is an upper limit on the supply.
But a more useful metric is the shares available for trading at any given time called the “float.” This doesn’t include shares that are effectively being held long term and not available for trading. According to Yahoo Finance data, GameStop’s float is estimated to be 47 million shares. But the actual number of total shares available for trading is likely quite lower.
In a typical rally, large institutional investors accumulate stock during a consolidation phase, eating up the supply shares. After a time, the trading float gets low enough that incremental purchases at the margin start moving the price more. Usually, there’s a catalyst, such as an earnings release, which sets the stage for a dramatic breakout due to increased interest and demand. The recent breakout in Microsoft (MSFT) from a seven-month consolidation after its Jan. 26 earnings announcement is an excellent example.
In a short squeeze, the dynamics are a bit different. Large institutional investors are more likely to be short a stock, and the resulting pop can be much more violent due to supply and demand.
To short a stock, a hedge fund or retail trader needs to locate it to borrow with the help of a broker. For a fee, the trader borrows the stock and is legally allowed to sell short the stock — betting on lower prices from which to buy the stock, thus “covering” or closing out the position. The bigger the short position, the bigger the potential surge.
Shorting a stock without borrowing it first (a “naked short”) is generally not permitted except by market makers, which do this to stabilize price. In addition, regulators sometimes ban short selling with the hope of mitigating the fallout from a sell-off. During the Global Financial Crisis in 2008, regulators banned bank stocks from being shorted — though even the New York Federal Reserve has concluded that those efforts failed to stem the losses.
Due to some shares being borrowed more than once, short interest can be bigger than the float — or even the shares outstanding. At the beginning of the GameStop squeeze, S3 Partners estimated the short position in GME as 140% of the float. Today, S3 estimates short interest has fallen by half over the last week, taking pressure off the price swings.
Once the price starts increasing in a heavily shorted stock, weaker hands are forced to cover their shorts at higher prices. This buying further drives up the price, which is often exacerbated by borrowing fees also increasing. If the stock price surges too much for stronger hands to hold, shares can skyrocket with the stock going parabolic. These dramatic moves are easy to identify on a chart as a short squeeze.
Short squeezes can occur in other markets too, such as the breakout higher in silver futures (SI=F) Monday above $30/oz. (However the dynamics are different and a topic for another day.)
It’s different this time
There are a number of reasons why the recent spate of short squeezes are unlike anything Wall Street has seen before. First, retail buyers now constitute an increasing percentage of the market — as much as 25%, up from only 10% in 2019.
Over the past few years, brokers have competed to offer commission-free trading, with Robinhood leading the way. And they’ve also added other bells and whistles to attract new traders. Fractional shares, smaller account minimums and the ability to buy call options all add fuel to the retail trading frenzy.
Buying calls
Retail traders are not only buying stocks outright, but they are also buying calls, which have leverage embedded in them. This means a trader can control more stock with a lower initial cost outlay.
In years prior, only sophisticated retail traders typically traded options due to the inherently riskier nature of these bets. Selling (or writing) call options has potentially unlimited downside risk as the price goes higher (think Tesla (TSLA) since 2020). But call option buyers only stand to lose their initial cash outlay.
Each options contract controls 100 shares, and a call option buyer only pays for the cost of the options contract. That cost can be quite cheap with a potentially large payout, but the price of the stock would have to increase substantially for the bet to win in these cases.
If upon expiration, the price of the stock settles above the options’ strike price (settling “in the money”), those shares are assigned to the call option buyer. If an account doesn’t have enough money to cover the price of the options, the broker will liquidate all or a portion of the options trade before expiration — in other words, the trader could be cashed out, as was the case with many GameStop long positions last week.
There are both weekly and monthly options contracts on stocks. Weekly options expire each Friday and monthly options expire on the third Friday of each month. These are often high-volume, volatile battleground days, when the stakes are elevated over the closing price in the underlying stock that day.
Counterparty risk
Recently, due to the magnitude of the short squeezes — primarily concentrated in names held by retail traders — another factor called counterparty risk is adding even more uncertainty and confusion.
Robinhood had so many customers piling into the same stocks, which were all getting squeezed simultaneously, that it was getting its own margin calls. When a trader buys a stock, it is not actually delivered until two days after the purchase, which is called “T+2 settlement.” Yet the broker is on the hook for any unrealized (or paper) profits and losses in the meantime. If market volatility threatens to make the number too big, Robinhood’s counterparties, such as Citadel, can request more cash to lower the risk that Robinhood itself poses to them.
Brokers that pay for Robinhood’s order flow (or customer trades) were demanding more cash because of the increased volatility and risk to them. In response, Robinhood tapped lines of credit and raised $3.4 billion from investors, seeking to shore up its capital position.
In addition, hedge funds like Melvin Capital Management were forced to take in new money to shore up their balance sheets after sustaining dramatic losses in January.
Robinhood even took the rare step of eliminating the ability to enter new trades in several stocks, sparking outrage among investors. (Investors always retained the ability to close existing positions.)
Other brokers eliminated or lowered the ability to trade on margin — requiring positions to be 100% funded. While this is perfectly normal and routine for brokers given the increased risk from their customers — this too rankled new investors who accused brokers of colluding with the short sellers.
Frequent broker outages by most of the names favored by retail investors only amplified the chaos and confusion.
What’s next?
The recent Wall Street Bets and Reddit-fueled stock buying phenomenon will be studied by market technicians and historians alike for years to come. Fortunes have been made and lost in the span of a week. Thinking ahead, an investor looking up “short squeeze” in the dictionary might one day see a picture of the GameStop logo.
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