Short Squeezes Before Margaritas

Before our waitress brought over our margaritas... and before I (Jeff Havenstein) had a chance to decide whether I wanted a chimichanga or a burrito... my sister began bombarding me with questions about GameStop (GME).

I'll admit... I was caught off guard.

Our dinner conversations usually don't involve talk about stocks. In fact, they never do. She knows I write about the markets for a living, but she has little interest in the topic – aside from how her 401(k) is doing.

The truth is that over the past several weeks, I've found myself talking to more people about stocks than ever before. Even old friends, who I haven't talked to for what seems like ages, have been blowing up my phone to get my opinion.

And I'm sure I'm not alone.

Discussions about stocks like GameStop, AMC Entertainment (AMC), and BlackBerry (BB) have been dominating dinner tables lately. Folks who had no interest at all in the stock market are suddenly becoming giddy investors overnight.

My sister blurted out to me, "So tell me everything about GameStop. Should I buy?" I was curious, so I asked what she already knew about the stock.

She said she heard a bunch of regular people were making hundreds-of-percent gains overnight with GameStop... and they were doing it by taking on Wall Street.

That's the message the financial media has been peddling... Novice investors versus Wall Street... The everyday man versus America's elite... Some outlets have gone as far as to call it "David versus Goliath."

Trying to give my sister the whole story, I started talking about GameStop's dying business and how that has lead to a lot of hedge funds selling short the stock... and then what exactly was driving the price of GameStop higher.

It didn't take long for me to realize her eyes had glazed over...

As soon as I started talking about "short squeezes," she started to tune me out. She became more interested in the chips and salsa at the table. It was information overload.

But my colleagues and I have gotten lots of questions from people asking to explain what has been happening in the market and what, exactly, a short squeeze is...

Short squeezes are nothing new, as they have been happening for many decades... but they're all the talk lately. And it seems very few people understand exactly what they are.

To begin, let's first talk about what happens when someone shorts a stock...

When you want to sell short a stock, you're doing it because you believe the stock price will go down. Maybe the stock is overvalued, or the company is losing too much market share to competitors.

In the case of GameStop, it quickly became a dinosaur. Most video games can be sold online. So there's really no need for physical discs anymore.

You can compare GameStop with the infamous Blockbuster back in the early 2000's.

Folks who want to short a stock like GameStop first have to borrow shares from a shareholder. (You can't sell what you don't have.) Once they borrow the stock, they can then sell it. And when they want to close the position, they have to buy it on the open market to replace the shares they borrowed. (The short seller's broker handles all the borrowing.)

A short squeeze happens when there are many traders shorting the same stock.

One way to tell if there are a lot of folks betting against a stock is by looking at the stock's short interest.

Short interest tells you the number of shares sold short as a percentage of the stock's float, which is the number of shares that are actually available to trade.

Let's say a company has a float of 20 million shares. If 5 million of those shares are sold short, that means the short interest is 25%. And that's pretty high.

You can see below how companies like GameStop and AMC have a high short interest compared with blue chips like Microsoft (MSFT) and Coca-Cola (KO).

 

Here's the thing when you short a stock... Unlike when you simply buy a stock and can only lose 100% of your money, the potential loss is unlimited when you sell short.

If you short a stock at, say, $50, and the stock goes to $100... you lost $50 or 100%. If the stock goes to $200, you lost $150 or 300%. There's no limit on how high the stock can go, which means there's no limit on what your loss can be.

When a trader takes a big short position against a stock, he or she doesn't want to risk a massive loss. So the trader is usually quick to close out the short position before the stock runs up too much.

This is especially true for big hedge funds that have billions of dollars at stake. You probably heard that hedge funds that had a short position in GameStop lost billions of dollars as the stock price rose.

That's because to close out your short position, you have to buy back the stock at market prices. So if many short sellers are trying to cover their shorts at the same time, there is a tremendous amount of buying pressure. And that will send the stock higher.

Then, the higher the stock goes, the more short sellers have to cover... which keeps it going even higher. This cycle is vicious. It can send a stock soaring in a very short amount of time.

Trust me, you do not want to be on the other end of a short squeeze. Just ask Melvin Capital, which had a large short book with stocks like GameStop and lost 53% of its portfolio in January.

But like I said earlier, short squeezes are nothing new. Clever investors have been profiting from them for a long time.

As an example, Doc targeted a stock in late 2017 that was heavily shorted. He thought Match Group (MTCH) was in a great spot for a short squeeze. Here's what Doc told his Retirement Millionaire readers four years ago in a section titled "Let's Squeeze the Shorts"...

Other investors out there don't like Match Group. We know because about 21 million shares, or 16% of outstanding shares are positioned as shorts – investors betting against the stock.

We think we've outlined the bull case for Match well. If we're right, we could get an extra boost from a "short squeeze."

He later wrote...

It gets even better... Match Group's parent company IAC/Interactive still owns 19% of outstanding shares and isn't selling. That tightens the supply even further.

In the case of Match, a little upward momentum could spark a snowball effect that pushes shares higher. We'll be along for the ride.

Doc's prediction of a short squeeze was spot-on. Readers who acted on Doc's advice are now up 436% on Match Group. (Match is unique because it was heavily shorted and is also a fundamentally terrific company.)

Now, Match had a short interest of 16% when Doc made this recommendation. GameStop recently had a short interest of 121%...

That's why the gains for GameStop have been so enormous.

With an influx of new Reddit buyers (the online forum where the push to buy GameStop came from), all the folks who shorted GameStop have to buy the stock to cover their shorts... and that's a reason for the recent mind-boggling gains.

Goldman Sachs says that this latest market madness is the biggest short squeeze in the past 25 years.

The most heavily-shorted stocks have rallied 98% over the last three months...

It's unheard of. The story of GameStop will likely be discussed in every business school class from now on.

But there's one thing about short squeezes... They don't last forever. And there's usually extreme volatility from one day to another (as we've been seeing recently).

There's a high chance you'll get burned if you try to jump into the market today and try to ride the next squeeze higher.

My advice? Wait for the dust to settle. And if you just can't help yourself and want to get in on the Reddit action, don't wager too much.

My good friend told me the other day that he was "about to take out a second mortgage to invest." Let's just say I talked him out of it...

Put simply, what we're seeing today is not normal market behavior. Don't get suckered into these risky trades with delusions of quick 100% or 200% gains. In the weeks to come, you'll hear plenty of stories about everyday investors getting in over their heads and losing everything.

It's a strange time in the market for sure. Be careful.

That's why, if you haven't watched it yet, you should check out Doc's special briefing on the stock market. Doc sat down with colleagues to discuss what we see happening in the market in 2021, their top recommendations of the year, and the simplest way to build a successful portfolio.

Click here to watch it all today.

What We're Reading...

• Hedge fund Melvin Capital is down $4.5 billion after epic squeeze.

• GameStop shares fall another 35%, lose more than half their value in two days.
• Something different: Tom Brady open to playing beyond 45 as he prepares for 10th Super Bowl.

Here's to our health, wealth, and a great retirement,

Jeff Havenstein and Dr. David Eifrig
February 3, 2021