Every once in a while an arcane topic jumps from obscurity into the headlines. Such was the case this week when everyone was talking about the “short squeeze” on Wall Street. Below I’ll explain what happened then offer thoughts on how you might respond.
What does it mean to short a stock? In simple terms, it means that you’re betting a stock will decline in price.
How does one accomplish this? It’s a three step process. First, you borrow the stock from another investor who owns it. Then you sell it. But of course, you’ll eventually need to return it to its original owner, so you’ll have to buy it back later. But since you’re betting that the price is going to drop, your hope is to pay less when you buy it back and then keep the difference. Here’s an example: Suppose you sell a stock for $10. If you can buy it back later for $8, you’ve made a $2 profit.
How do you borrow a stock from another investor? The most common lenders are mutual funds, which lend out their holdings in exchange for “rental” fees. For some mutual funds, this rental income can be substantial. In fact, there have been cases in which an index fund has beaten its own index—a seemingly impossible feat. Part of how they can accomplish this is by earning income from lending out their holdings. In 2019, for example, Vanguard’s Total Stock Market Fund brought in more than $150 million this way.
What is the risk in short-selling? In the example above, an investor borrows and sells a stock at $10 then buys it back at $8, happily earning a profit of $2 when the price drops. But what if the price goes up instead? Then the short-seller has a problem because they still need to buy the stock back to return it to its owner. The higher the stock goes, the bigger the problem for the short seller. Suppose the stock goes from $10 to $15. Then the short-seller is looking at a $5 loss. If it goes to $25, the prospective loss grows to $15. Because of this, short sellers are exposed to potentially unlimited losses.
What is a short squeeze? This potential for unlimited losses can cause a phenomenon known as a short squeeze. When the price of a stock rises significantly, short sellers begin to panic. Recognizing the potential to be completely wiped out, short sellers will scramble to buy back shares so they can cap their losses. But this isn’t always easy. If a stock is being widely shorted—known as a having a high “short interest”—there may not be enough shares available to buy back. This causes the panicked short seller to bid higher, hoping to capture shares at any price. This causes the price to go even higher, inflicting further stress on other short sellers. The cycle then intensifies as the price goes higher and higher.
What happened most recently? A group of investors on a message board called WallStreetBets started discussing stocks with high levels of short interest, including money-losing video game retailer GameStop. It’s difficult to say how many investors it took to initiate the squeeze on GameStop, but aggregate trading volume paints a picture. Most days, fewer than 10 million shares change hands. But this week it grew to nearly 200 million shares. Along the way, GameStop’s share price rose geometrically. A few weeks ago, it was trading under $20 a share, but on Monday of this week it topped $75. On Tuesday it nearly doubled to $148. On Wednesday it was close to $350. Yesterday, it topped $450 in pre-market trading before dropping back. This morning, it nearly doubled again in the first 15 minutes of trading.
How bad did the short squeeze become? It’s hard to quantify the losses, but what is known is that two hedge funds threw in the towel on their short bets. And at least one fund, Melvin Capital, was forced to accept a multi-billion dollar lifeline and had to deny rumors it was headed for bankruptcy.
What happened from there? Almost immediately, opinions came in from all sides. One government regulator called for a 30-day trading moratorium on GameStop shares. But on Thursday, when the broker Robinhood implemented a ban on purchasing GameStop and other similarly targeted stocks—a ban that I thought made good sense—it was met with vitriol from those who viewed it as an attack on the rights of small investors. Late in the week, a class action lawsuit was filed against this broker, and multiple members called on the SEC to investigate.
Why did this happen now? It’s usually hard to pinpoint the origin of a mania. In a lot of ways, this is just a continuation of what we saw last year, when the advent of zero-commission trading, Internet personalities who say “stocks only go up,” and millions of people with more free time working from home, all fed a booming stock market. But in this case there is an identifiable precipitating event: About three months ago, one member of the WallStreetBets message board put together a video in which he outlined the exact scenario that played out with GameStop.
How should you as an individual investor respond to all this? These are my recommendations:
- Be careful of FOMO—the fear of missing out. I’m sure fortunes have been made this week, and this makes it all look very easy. But this isn’t investing. I’m not sure it even deserves to be called speculation. One famous investor called it “unnatural, insane and dangerous.” That sums it up well. I’d stay far away from it.
- If you’re fortunate enough to own a stock that’s run up hundreds of percent, I’d sell it immediately. Yes, it could go higher, and you might get a better price tomorrow. But to state the obvious, it could easily go the other way, and quickly.
- Don’t get scared out of the stock market. One of the unfortunate side effects of manias is that they scare sane people and can cause them to become overly cautious. If the current mania makes you uneasy about the stock market, that’s understandable, and I’m right there with you. But I would urge you to stick to your plan. As we saw last year, the market has a mind of its own and rarely responds in a predictable way. So don’t let the recent madness knock you off course. I would stick with your asset allocation and try to tune out the noise.
- Be prepared for more volatility. When I watched the WallStreetBets video referenced above, it reminded me of the children’s movie in which the villain has a plan to steal the Moon. It seemed delusional. And yet it actually happened. A loosely-connected group of small investors used the power of online message boards and social media in a way that nearly brought down at least two multi-billion-dollar hedge funds. This isn’t something we’ve seen before. But I suspect we’ll see more of it, so it will be even more critical in the future to be able to tune out the noise.