Understanding the GameStop Saga — Part Two: Anatomy of a Short Squeeze

In the previous post, we examined how the brick-and-mortar meltdown as well as the pandemic put physical stores like GameStop under great stress. This made it an obvious target for investors, including hedge funds, who were betting on continued decline of the business and corresponding stock price.

In this part, we will look at how this can be made possible and the mechanisms that made the short-squeeze whiplash possible.

Photo by 50Fish

PART II: Anatomy of a Short Squeeze

There are many reasons why people buy and sell anything, but the most fundamental motivation to be on either side of a trade is this:

• Buyers are betting that the stock will rise in value in the future.
• Sellers are betting on a falling price in the future.

As opposed to a regular selling where an investor owns a number of shares of a stock and then decides to sell them, short selling (or just shorting for — uhm — short) happens when the seller does not actually own the shares. The shares are first borrowed (from a broker) and sold immediately, with a promise to buy back (and deliver) the share at some time in the future. But why would anyone want to do that?

Picture this. It is summer of 2015. Myanmar became a democracy and Adele is still singing Hello. You are enjoying your vacation by the beach, wiggling your toes in the sand and patiently waiting for your cocktail as you perceive something shining in the sand two feet away. As you unearth it, you realize it’s your luckiest day! An oracle ball. You brush and shake your precious future-predicting device and, lo and behold, words appear:

August 2020: GME @ $1.000

Being a savvy investor, you hurriedly reach out for the other device in your backpack to check the stock market:

Today: GME @ $20

What shall you do?

If the oracle told you that GME will be $100 by 2020 that would have been easy. Why of course you would buy as many shares of GME as you can and hold them until 2020. Multiplying your investment 50 times in the process.

However, as the predicted price is significantly lower than today’s, how can you benefit from this information? If you already owned the stock, you want to get rid of it as soon as possible. Otherwise, you can’t do much to profit from your oracle prediction, can you? Well, with short selling you can. Remember, it allows you to bet and profit from falling market prices. You short sell the stock today for $20 and buy it back in 2020 for $1, if the oracle prediction materializes, making a good and certain $19 profit on each share. Not bad!

And just as in our oracle ball example, many professional investors who have appetite for risk and access to short selling strategies (hedge funds) piled up on GameStop and others: It was evident that GME constituted an ideal target (given the problems and structural issues discussed in Part I) — no need for an oracle ball (just some research.) However, direct short selling comes with many risks — especially when investors get complacent as happened in this case.

• Borrowing costs: when shares are borrowed, the broker may charge interest and fees on the amount borrowed, especially when a stock is in short supply.
• Asymmetrical loss potential: In an ordinary buy transaction, the worst an investor can lose is 100% of their initial investment. You may ask, what is worse than losing all of my investment? Potentially, much more. Let’s assume the oracle ball is infallible and you trusted its prediction:

Suppose you are a European. You read the predicted price to be a thousand dollars (separator.) You went out and bought 100 GME stocks in 2015 for $20 (total value of $2,000.) To your horror, it turns out the ball is American (Made in China.) In 2020, at a $1 a share, you lost $1,900 (95% of your investment). Shortly after, the company goes bankrupt: you have just lost all your investment: the maximum you can lose any case (because a price can’t be negative.)

Now suppose you are an American and thought the prediction said $1 because, well, it’s just precise to the 3rd decimal point. You shorted 100 shares of GME stock in 2015 for $20 (at $2,000). However, the damned ball was actually predicting a thousand price tag but you only find this out too late. Fearing the stock will just keep on rising, you buy back the 100 shares at $1,000 (spending $100,000) you have just lost $98,000. Same initial number of shares as in the first scenario but with an outsized loss potential. Worse, there is no upper limit to how much you can lose — theoretically, infinite. This is not exactly how the profit-and-loss works but it illustrates the two defining risk characteristics of short selling: asymmetry and infinite potential loss.

Illustration: Asymmetrical Loss Potential

• Margin costs: In a regular buy transaction: while an investor is holding a stock, the value may fluctuate, sometime wildly, but they are not impacted as long as they are holding the stock. No additional cash is tied to the transaction beyond the initial investment. In short selling however, to compensate the broker for the risks of lending the shares, the short seller must post some collateral: a sum of money, referred to as margin account — like a deposit. As long as the stock price is dropping or stable, the short seller is ok. However, if the stock starts to rise, to compensate the shares lender for the increased risk, the short seller will have to pledge more cash as collateral. We are talking about one of the most dreaded words on Wall Street: A Margin Call. Liquidity is a very important component of markets and is a big source of instability when it is restricted as it has potential to cause domino effect.

Example of Margin Account P&L in the Case of a Short Sell

And this is why direct short selling can sometimes be a source and accelerator of instability in markets not just for the stock in question but the overall market.

In a short supply situation, a small price increase (for whatever reason) leads to margin calls, which would trigger partial liquidation (short covering by weak hands) leading to more buying pressure and faster rise in the stock price. Which again triggers more margin calls and more liquidation and stronger buying pressure. This is what is referred to as a short squeeze. The cycle continues until:

1. In normal conditions: it stabilizes where supply and demand are in equilibrium.
2. In oversold conditions: it gets out of hand quickly and violently. Leading to more instability — violently veering one way then the other. In extreme situations, the repercussions go beyond the stock in question to the overall market (margin calls leading to liquidation of other positions by trapped short sellers, leading to panicked sale of other stocks and other assets (to finance these margin calls) causing downward price pressures on these assets, contagion, bigger losses, liquidity crunch, failure, or bankruptcy.

Two Scenarios: How a Short-Squeeze Occurs

As of early January, GME stock was the most shorted stock on the market (to such an extent that there were more shorted shares than there are shares available for trading.) Many other names were also heavily shorted. Which made them ripe for a violent short squeeze given the right trigger.

Many small amateur day traders on social media realized that they can target these most-shorted names with sustained buying until they trigger a short squeeze realizing outsized gains and causing hedge funds on the other side of the trade substantial losses.

In the next installment, we will turn our attention to something more bubbly.