Shorting the Short Sellers? Quarantine and Financial Madness

NOTE: This blog post does not promote investment advice. Speak to a financial advisor.

Gamestop, Bed Bath & Beyond, Tesla Motors, Macy’s, Virgin Galactic.

What do a few struggling brick-and-mortar companies have to do with the King of EV and an English billionaire’s potentially stillborn spaceflight company? They are all part of an assortment of companies that are heavily sold short.

Short-selling is when an investor borrows a stock, selling it immediately at a high price, hoping that the price will drop such that when they return the borrowed stock, they made a profit. It’s basically a way of profiting off the prediction that a company’s stock price will plummet.

So an investor will tend to short a stock if they thinks its gonna tank. We would, because of the efficient market hypothesis, therefore perhaps believe that these stocks should perform rather poorly compared to the broader market.

Yet numerous observers, for instance Seeking Alpha, have realised the opposite is happening!

As seen in the graphic below, a Goldman Sachs basket of the most heavily shorted stocks has outperformed the market since the beginning of lockdown!

You can find a list of the currently most heavily shorted stocks here.

Here’s some of the first few results.

Lets look at a few examples.

First of all GameStop, the brick-and-mortar gaming retailer undergoing an attempt to transition into e-commerce. GameStop is currently most shorted stock on the NYSE. We find the stock has more than tripled since its all time low.

GameStop price trend, from Google.com

From the other end of the pile, Tesla’s price has quadrupled in a similar time-frame.

Tesla price trend, from Google.com

Both stocks, fundamentals notwithstanding, have outperformed the S&P500. A culprit in this commonality, might be the infamous short squeeze.

The Short Squeeze

So what’s a short squeeze? Its a phenomenon which happens when a lot of investors short sell the same stock, and the price of the stock unexpectedly rises. This means that the short-sellers profit evaporates, and can produce a situation where they wish to close their position immediately to stop any further losses.

How can they close their positions? By buying the underlying stock. When a large percentage of the underlying stock is short-sold, this has the potential to provoke an enormous cascade of short positions being closed and concomitant forced buying of the underlying. The result is an upward explosion in the stock price as short-sellers clamour to minimise their losses.

Of course significant short squeezes are rather rare. The worst in recent history was the Volkswagen Infinity Squeeze. Porsche was attempting a hostile takeover of Volkswagen, which was undergoing financial troubles. Volkswagen was hence heavily shorted. One day Porsche announces they have surreptitiously bought 75% of the company through shares and options (another 20% owned by the German state of Lower Saxony), leaving only 5% of the total shares available for short-sellers to cover their positions — a mathematical impossibility. The stock shot to the moon for a couple of days, until Porsche kindly eased the pain of the short sellers by selling off stock.

Volkswagen short-squeeze. Source

This hyperbolic example is merely a caricature of the usual dynamics of short-squeezes. Financial institutions have long wised up to the pitfalls of shorting stocks, and by now use complex hedging strategies when they short stock. However it holds relevance to current trends. For example Tesla’s meteoric rise this year may be partly explained by an enormous dragged-out short-squeeze.

Quarantine Finance: The Short Squeeze Factory

So what happens in milder cases when a stock is shorted and its price suddenly rises? The short seller will most likely close their position temporarily and wait for another all-time-high for the stock before reopening it (assuming they remain convinced of the stock’s ill prospects).

If a significant number of shares are short-sold, this can lead to sudden price rises, especially as boards such as WallStreetBets and other retail investors pile onto suddenly ‘booming’ stocks.

As the price reaches a certain high, retail and institutional investors cannot justify buying in at that price. This is where the short-sellers reopen their positions. They borrow shares of the underlying and sell them at the new high, putting downward pressure on the stock. As the stock has already reached a peak, this sudden downward movement scares investors into selling their ‘long positions’, provoking a sudden drop in the stock price.

When the stock’s price drops, the volatility and lower price attract numerous trading-bots, day-traders, retail investors with FOMO, etc. Similarly, the short-sellers want to close their position with a profit before the stock price rebounds. This leads to enormous upward momentum in the stock price, repeating the cycle.

GameStop price trend, from Google.com

I’ll repost the GameStop graph, as its quite exemplary of this cyclic sway.

So why is this trend apparently becoming pronounced only in 2020–2021? An educated guess: financial stimulus and retail investors.

Financial stimulus has a tendency to inflate stock prices, detaching them from fundamentals. Similarly the work-from-home environment and excess savings produced by the lockdown have formed an unholy trinity with apps such as RobinHood and social media hubs such as WallStreetBets, wherein retail investors have more money and coordination than ever before.

The end result? Companies like Tesla trade at 40x their revenue, and retail investors buy stocks of already bankrupt companies.

In this kind of environment, the efficacy of shorting a stock is significantly reduced. As the old adage goes: “the markets can remain irrational longer than you can remain solvent.”

Thank you for reading. If you enjoyed this post, you might like:

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