The recent surge of huge price swings in shares of GameStop (GME -0.47%) has been nothing less than mesmerizing. GameStop's stock soared nearly 700% in just five trading days as of the middle of last week, only to plunge 44% one day later. Then on Friday, GME shares rebounded to rally more than 50% on that day alone. AMC Entertainment's (AMC -3.28%) stock jumped 300% last Wednesday, fell more than 50% on Thursday, and jumped more than 50% again on the final trading day of last week.
The underlying reason? Investors believe they have identified a misstep a few fund managers made. Specifically, this crowd of individual investors collectively forced these funds to buy the stock by creating what's called a "short squeeze."
The price volatility that was on display last week (and has continued into this week) is worth a closer look for a couple of reasons, not the least of which is the fact that this sort of price speculation is something most investors shouldn't even attempt.
Still, it's a fascinating story.
What's a short squeeze?
Shorting a stock is the act of selling high and then buying low. It's the same "buy low/sell high" premise that motivates all investors. The difference is simply the sequence. Short sellers sell a stock they have borrowed (but paid a small fee for borrowing) in anticipation of what they suspect will be a significant price drop, and then they buy the stock back later at a -- hopefully -- lower price and return it to the borrower.
Yes, it's perfectly legal. It may not be advisable, and the practice dances with the moral hazard of price manipulation, which is (generally) illegal. When a lot of a company's stock is sold it sometimes generates a self-fulfilling prophecy by making the stock less appealing to potential investors, lowering the price further. Short-sellers aren't breaking any law, however, by betting against a company in this way.
A handful of hedge funds did this very thing in big way with GameStop stock over the course of the past few months. Melvin Capital, Steve Cohen's Point72, Dan Sundheim's D1 Capital, and an outfit called Citron were among the names most associated with the holding of millions of shorted shares of GameStop headed into last week.
Here's the catch in executing a stock short: These short trades eventually have to be closed out, and the only way to close them out is by buying back as many shares as have been shorted to "cover" the short position and return the borrowed stock.
This is where the risk in short-selling lies. If you own a particular stock the most you can lose is the entire amount of capital invested in that stock. The worst-case scenario is that the stock's value tumbles to zero. But the risk in selling a stock short is theoretically infinite since there's no ceiling on how high a stock's price can rise.
What happened in the case of GameStop
Enter the army of individual traders looking to capitalize on a rarely seen opportunity.
On the Reddit online social forum, a subgroup (known as a subreddit) called r/WallStreetBets (where investors gather to talk about the stock market and share ideas) had a participant who pointed out a curious quirk about GameStop's stock. The participant noticed there were more shares shorted than there were shares available to trade. The shares available are called the "float."
If your investing gut says this is a problem, your gut is right. When there's far more potential short-covering demand than there are actual shares available to buy, investors who hold the stock can name almost any price from those looking to buy. The trick is simply nudging the stock upward enough to cause fund managers who hold short positions to lose their nerve and start their panic-driven buying spree. Of course, once the buying spree starts and forces the stock a little higher, further panic ensues, inducing more buying, prompting more panic, driving more buying ... you get the idea. That's the "squeeze."
Enough of those small-time traders on Reddit were able to do this very thing with GameStop last week. The rally reversed in a big way on Thursday when, in an effort to curb volatility and help ensure conformity to government holding requirements, a few brokerage firms barred any new positions in the stock. But the bullishness resumed on Friday when most of those brokerages reinforced their financial positions and once again allowed new positions in GameStop. And why not? While some funds' short positions have been covered, others haven't. It appeared at the time that there were still several million shares shorted than there are in the float, setting the stage for continued buying pressure.
In some ways, you have to cheer the little guys' victory. They banded together to push back against major players that some say wield a little too much pricing power over stocks. Other fund managers may think twice in the future about using their influence to drive a stock they've shorted to a lower price.
For most investors, however, hunting for short squeeze candidates isn't the best use of time or money. For every success story like GameStop's, there's an untold number of short-squeeze candidates that never took off. By and large a stock that's being heavily shorted is a stock that's being heavily shorted for a reason. You will be far better off financially by finding companies that are strong long-term investments and buying and holding that stock.