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Understanding a Short Squeeze

S Rossi 2014
Stephen A. Rossi, MBA, CFA®, CFP®
Senior Vice President, Senior Equity Strategist
[email protected]
(585) 419-0670 x50677

Published on March 9, 2021 in the Rochester Business Journal

If someone were to ask you what a short squeeze was, you might be tempted to describe it as a hug or a brief embrace usually associated with a greeting or a goodbye. In the investment world, however, a short squeeze is anything but friendly and the adverse financial consequences associated with this type of event can be severe.

Before examining the mechanics of a short squeeze, one should first understand the concept of a long position versus a short position. When an investor takes a long position in a particular company, it means they have purchased shares of stock (i.e. ownership in the company) expecting that the share price will go up over time. If it does, the investor can sell the shares for more than they paid for them and profit from the transaction accordingly. Conversely, if an investor takes a short position in a particular company, it means they sold shares in the company – specifically, shares they didn’t own – expecting that the share price will go down over time. If it does, the investor can profit by buying the shares back for less than what they initially sold them for. In other words, taking a long position is a bet that a particular stock will go up in price, while taking a short position is a bet that a particular stock will go down in price.

At this point, you might be wondering how you go about selling shares of a company you don’t actually own to take a short position. The simple answer is you borrow them from someone that does own the shares and pay interest on the value of the shares you borrow. This is accomplished using something called a margin account. In a margin account, investors use the securities they own as collateral for the shares they borrow and sell to take a short position. Margin accounts are offered by broker-dealers and customers that sign a margin agreement can usually borrow up to 50% of their marginable investments. Most, but not all, publicly traded securities are marginable.

Understanding the consequences of taking a long position in a company is pretty straightforward. If you buy the shares and they go up, you end up with an unrealized gain (i.e. a profit). If you buy the shares and they go down, you have an unrealized loss – often called a paper loss. Gains and losses aren’t actually realized until you sell the shares for more or less than what you paid for them. Either way, since you initially bought the shares to take a long position, there’s no margin interest or collateral shortfalls to worry about, as might otherwise be the case from time to time when taking a short position.

The consequences of taking a short position in a particular company – otherwise known as selling short – can be a bit more complicated. As mentioned above, if you borrow someone else’s shares and sell them, and the price of those shares then goes down, you can simply repurchase the shares at a lower price, return them to whomever you borrowed them from and profit on the difference in price between the time you sold the shares and the time you bought them back. It’s when a stock is sold short and the share price subsequently goes up that things get interesting, and a bit more dangerous. When a situation like this occurs, unrealized losses begin to accumulate – remember, you sold someone else’s shares and you’ll have to buy them back and return them at some point. If the price of the shares goes up after you sell them, instead of down, that can be a problem. The reason is that the cost of repurchasing those shares begins to rise.

When selling short, you need to maintain a certain amount of collateral to secure the margin loan you took when you borrowed a third party’s shares. When the price of the borrowed shares goes up, you’re left with less and less collateral, all else equal, to support and enable the repurchase of those shares. When the value of your collateral gets too low, you’ll receive a margin call and you’ll typically be forced to put up additional collateral (i.e. cash) within 2-5 days or be forced to sell some of the securities you actually own to support your margin debt. When this happens, the leverage (i.e. debt) you employed to enhance your overall returns by taking a short position can start to sting - sometimes in a very bad way.

Understanding the mechanics of selling short, we arrive at the notion of a short squeeze. This occurs when outside forces begin to drive up the price of a particular stock and, specifically, one that other investors have taken large short positions in. As this happens, those that have shorted the security begin to experience unrealized losses. As the losses mount, these investors eventually receive a margin call and are forced to put up additional collateral to secure their margin loans. When the situation becomes extreme and the short sellers run out of additional collateral, ongoing margin calls can force the sale of other securities that are owned by the shorts, to generate enough capital to repurchase the shares that were shorted and return them to the lender. In the process of repurchasing those shares, the share price of the security is driven even higher, further squeezing those that initially took the short positions. This can force additional margin calls and/or share repurchases, as was dramatically on display with recent trading in the shares of GameStop. When the leverage of borrowed funds starts to work against you in this manner, it can become a vicious cycle where losses beget more losses.

Taking short positions and borrowing in margin accounts is not for the faint of heart. Too often, investors are drawn to the idea of accelerating their investment returns by making use of leverage – the focus, of course, being on the rewards that the leverage can provide. One should always remember, however, that with great reward comes great risk. When it comes to the risk and reward of taking a short position, many find out only too late that the metaphoric juice simply wasn’t worth the squeeze.

To see this column in the RBJ, click here.

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