"Of course there is always a reason for fluctuations, but the tape does not concern itself with the why and the wherefore. It doesn't go into explanations. I didn't ask the tape why when I was fourteen, and I don't ask it today, when I am forty... What the dickens does that matter?"
-Edwin Lefévre, Reminisces of a Stock Operator
Building a narrative to explain movements and gyrations in the capital markets is difficult and most often fruitless. We're given many incoherent clues that don't exactly coalesce together nicely, and almost all of the time, the same clues rearranged in a slightly different manner yield a completely different explanation.
However, with the recent astonishing gains in GameStop and AMC share prices, it's a good idea to understand the anatomy of short squeezes and the major institutions involved behind the scenes.
Short Selling: u can sell stock u don’t own?!
“Shorting’s f**king amazing, I love shorting, I’m going to short you, short Sai, and then short Spikeball…”
Short-selling, or shorting, feels like some dark magic buried deep in the bowels of the investing world. We'll often hear it described as borrowing shares, which can feel confusing - it doesn't exactly make sense to borrow shares and collect cash for the sale when we don't own any of the shares trading hands. Shorting simply ascribes to the ever-persistent investing mantra "buy low, sell high", except in reverse. To provide a clearer picture, shorting is better described with the following analogy.
Suppose that we want to short sugar because we believe that the price of sugar is set to decline soon.
We go to our neighbor's house and borrow 1 kilogram of sugar.
Then, we sell the kilogram of sugar to a local lemonade stand for $3.
The price of sugar declines due to a glut of sugarcane from an exceedingly good tropical harvest.
We buy 1 kilogram of sugar from the supermarket for $1.50.
Finally, we return the purchased sugar back to our neighbor.
Let's also say that our neighbor charges us 10 cents to compensate for the inconvenience of not having the sugar in their pantry. When the dust settles, we’ve netted a profit of $3 - $1.50 - $0.10 = $1.40. The price of sugar declined and we've made money.
Investing on Margin: I Too Like to Live Dangerously
Since the proceeds from a short sale don't belong to us (only the profit or loss made does once we've closed the position), short-selling must be done in a margin account. Investing on margin involves using borrowed cash to buy and sell securities. Gains or losses from a short sale transaction are multiplied based on the amount of capital borrowed.
Let's say that we bought 100 shares of FB at $250 each. The shares appreciate to $300, and we sell all of them for a $30,000 - $25,000 = $5,000 total profit. We've made a 20% return on our initial investment of $25,000. However, let's assume that before initiating a buy order, we borrow an additional $25,000 from our brokerage against our own $25,000, and use the $50,000 in cash to purchase 200 of the same shares of FB. When they appreciate to $300, we sell all of them for $60,000 in total. You pay back your brokerage the $25,000 you borrowed, plus $500 in interest, leaving you with a profit of $9,500, a 38% return on your initial investment of $25,000. Leverage turns good trades into great ones.
While the above scenarios are exceedingly optimistic, using leverage can also amplify losses. Suppose that the we borrow the same amounts of capital and purchase the same shares, which decline to $200 per share. Selling the shares for a total of $40,000, and paying back the $25,000 borrowed plus $250 in interest leaves us with $14,750, a 41% loss despite only a 20% decline in the price of the shares.
If the value of the purchased securities declines further than the amount of collateral posted for the margin loan, then the brokerage can initiate a margin call, liquidating any or all securities in your account until the margin loan is made whole again. If the 200 shares fall to $125, your portfolio's value would consist of $25,000 in borrowed capital and $0 of your own cash. Your brokerage would sell the 200 shares, recoup their $25,000, leaving you with a total loss despite a 50% decline in the price of the shares.
While investing on margin is used to short-sell stocks, it is also widely applied within the capital markets. In the example above, we undertook 1:1 leverage, that is, borrowed $1 for every $1 we posted in cash. Futures trading with leverage is universal, and can range from 10:1 to 20:1 depending on the volatility of the futures contract being traded. Forex traders employ 100:1, 200:1 and even 500:1 leverage (that is, posting just $20,000 in cash allows you to trade $1 million) due to the smaller price movements in currency pairs. However, at 500:1 leverage, even a price movement of just 20 basis points (0.2%) in an underlying security can either double or completely wipe out your investment. Leverage is a double-edged sword that must be wielded carefully.
Borrow Rates: Never Been Lower… Well, Sort Of.
While short selling feels like the other side of the investing coin, there are some asymmetries that distinguish it from being the polar opposite of going long.
As we saw in our aforementioned example, short selling isn't free. We borrowed our neighbor's sugar, and had to pay the borrowing cost for initiating the sugar sale and leaving their pantry unstocked for a certain amount of time. In the capital markets, investors pay their brokerage borrowing costs following the sale of a security as long as their position remains "open". These investors will need to buy back their shares at a hopefully lower price in order to "close out" their position and to return the shares that they initially sold from their broker. These borrowing costs vary depending on the liquidity and availability of the shares to be shorted. A company with a smaller float and lower daily trading volume will incur higher borrowing costs because the shares needed to initiate a short sale will be more difficult for a brokerage to acquire. In contrast, a blue-chip stock with millions of shares exchanging hands daily will have rock bottom borrowing rates because the security is very liquid.
Apple (AAPL) is a blue-chip stock with very high liquidity, many shares exchanging hands daily, and a wide ownership base. Therefore, its shorting borrow rates at brokerages are very low, in this case, only 25 basis points (0.25%) annually.
Nikola (NKLA) is a mid-cap company with less liquidity, fewer shares exchanging hands daily, and a concentrated ownership base. It is more difficult for a broker to lend shares for short sale, which means that its borrow rates are much higher, in this case 435 basis points (4.35%) annually.
These borrowing costs put a serious clock on a short-seller. Whereas a bullish investor can nurse a long position for decades, a short-seller has to hawkishly manage their position while their borrowing costs rise. However, borrowing costs pose a relatively minor risk to short-sellers when contrasted with a short squeeze.
Short Squeezes: Producing Tenbaggers Overnight
Honorable Mention: Close but no cigar.
A short-seller is obligated to close out their position by buying back their shares and returning them to their broker at some point in the future. When a position is open, it's valued, or marked-to-market, as a negative value equal to the number of shares sold short multiplied by the average price per share sold. For example, if a short seller sold 100 shares of AAPL short at $130 per share, their broker would denote the position as -100 with a position value of -$13,000.
If AAPL rose to $150, then the position would be indicated as -$15,000, with a mark-to-market (MTM) loss of $2,000. If AAPL continued to rise to $300 per share, then the position value would be -$30,000, or a MTM loss of $17,000.
As we can see, the downside with short selling is potentially unlimited, whereas the upside is capped at 100%, should the share price fall to 0. Contrast this to a long position, where the downside is capped at 100%, and the upside is potentially unlimited, as a company's share price can continue to grow indefinitely.
The combination of mounting borrowing costs, MTM losses, and a hedge fund's leverage levels produces the short squeeze phenomenon. A company that has a high short interest (a large amount of publicly traded shares outstanding sold short) provides the seeds for a short squeeze. Suppose the company's share price continued to rise. This would mean that the big investors and hedge funds shorting the company's stock would face mounting MTM losses. Hedge funds almost universally employ leverage, anywhere from 5:1 to 15:1. Their margin loan lender would began to get nervous about their share repayment obligation, and may issue a margin call on their borrowed capital, forcing them to close out their position by "covering their short", and buying back their owed shares at a much higher price. More motivated buying pushes the stock price to higher levels, forcing more and more investors to cover their shorts while continuing to fuel a herding effect of motivated buyers.
As such, a short squeeze can result in some incredible price changes, completely dislocating a company's share price from its underlying fundamentals. Below are a few examples of stocks with heavy short interest that may have squeezed their shorts on their way up.
GameStop (GME) had a very high short interest, opening 2021 trading around 18 and surpassing 480 during intraday trading in mid-January. It is believed that GME's astronomical rise squeezed the hedge fund Melvin Capital's short position.
GME’s high short interest sowed the seeds for a massive short squeeze, denoted by the parabolic price jump and sky-high trading volumes.
AMC Theaters (AMC) also had a high short interest, opening 2021 trading near 2 but reaching just above 20 during intraday trading in mid-January.
AMC’s rising short interest precluded a major short squeeze which saw its common stock increase tenfold. It saw more than 1.2 billion shares change hands in one volatile trading session, sharply contrasted against its 50 million average daily volume.
Herbalife (HLF) was a target of a 2012 short-selling campaign launched by Pershing Square Capital hedge fund manager Bill Ackman. Ackman opened a $1B short position on Herbalife intending to profit off of a decline in its share price. Another investor, Carl Icahn, took a long position on Herbalife, claiming he liked the business' fundamentals. Icahn's position and influence pushed the HLF share price higher, squeezing Ackman's short and eventually forcing him to cover his position at a loss. Their opposing bets on Herbalife were the subject of the documentary Betting on Zero, and they infamously butted heads on a heated CNBC segment.
While the current market certainly presents anomalous volatility and movements, short squeezes stand out like supernovas, attracting every investor’s attention. In most cases, unless you have the appropriate gear, it's best to watch the fireworks from a distance. Actively trading a short squeeze involves timing the market, which is a near-impossible feat. A total market fund will incorporate a squeeze's returns as part of its growth, albeit on a much smaller scale.
Although short squeezes may have been the fuel behind most of this month’s market movements, it’s important to remember that there are many more narratives to build from our soup of clues. We’ll explore other technical market movements in the future, understanding how the adjacent derivatives market influences the beloved equities markets.
Disclosure: I, Rohit Sarathy, have no positions on any of the companies mentioned in this article.