While this trade has worked for now and is still expanding to other stocks, don’t confuse what is happening with investing. In addition, options dealers will look to charge higher premiums, thus greater implied volatility, on the options they sell in order to protect themselves against wild price swings. This could limit that natural balance between investors' opinions on whether a stock is over- or undervalued. However, after getting burned in a short squeeze, many of these investors will become much more hesitant to short stocks in the future. Shorting stocks helps to keep the market in balance over time as it provides a natural resistance for overvalued stocks to become even more overvalued. As losses are being racked up on the short positions, some highly leveraged funds may have to sell some of their long positions to cover their margins. Our guess is that many institutional stock investors who were long the stock prior to the rally have called their trustees in order to instruct them to pull their availability to lend the shares out.Īs the short squeeze rapidly expands across the markets, it appears that many hedge funds have looked to cover their shorts before they are next in line. The dealers that sold those call options then bought the stock to hedge their delta, the rate of change of options price due to change in underlying stock price.Īs the stock rose even further, those dealers were forced to buy even more stock as the price neared the strike price. The stock price really got moving as other investors purchased out-of-the-money call options. As the price rose, other short-sellers began to buy as their margined positions quickly moved against them. MORE ON THIS TOPIC: Investing shouldn't feel like a trip to the casinoĪs the stock price first began to rise, many of these investors were forced to buy the stock to cover their positions, which in turn sent the stock price up. With a short-interest ratio well over 100 per cent, many of the shorts were “naked,” meaning that they sold stock that they were not able to borrow, an especially precarious position. Prior to the stock rally, the short-interest ratio on GameStop hit 260 per cent at the end of last year. These situations are more of a cautionary tale of the inherent risks of shorting individual stocks, especially those that already have a high short-interest ratio. While we think the market is currently broadly overvalued, this phenomenon does not change our view of the market structure for long-term investors. And just like no one wants to try to catch a falling knife until it hits the floor, fundamental investors focused on the long term won’t re-enter the market until the stock is significantly undervalued. In a typical short squeeze, once all of the weak shorts are margined out of their positions and the forced buying ends, the stock price will come crashing back down to earth. However, once a short squeeze comes to an end, look out below. Make no mistake about it: During a short squeeze, the increase in the stock price has absolutely nothing to do with the long-term fundamentals of the company and everything to do with the short-term technicals. Like any other trading strategy that works in the short term, this strategy is starting to catch quickly and is spreading to other stocks with high short-interest ratios. Short investors were carried out on stretchers. All of this activity culminated in a stock price explosion from US$19 to as high as US$380 in intraday trading over the course of two weeks. What started on a Reddit board was then further amplified on Twitter by a few high-profile investors announcing their purchases of out-of-the-money call options. With its high short-interest ratio and availability to pile on additional leverage through the options market, GameStop ( GME) was a prime candidate for a short squeeze.
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