Three Things Investors Need to Know About the GameStop Short Squeeze

Before I discuss the “short squeeze,” I think it’s important to discuss two underlying concepts: a long position (AKA going long) and a short position (AKA “shorts”).  The average investor typically goes long. Going long means that the investor has purchased and owns a stock with the expectation that it will go up.

Speculative investors or institutions, usually hedge funds, who think a stock will go down might “short” a stock. Practically, the investor who shorts a stock does not own it. The investor borrows the shares (usually a brokerage firm) and, at some point, has to cover the trade or, in other words, give the stock back. The idea is that when the stock price goes down, the investor buys the shares at the lower price, gives the broker back the borrowed shares, and pockets the difference.

The Risk of “Going Short”

Let’s talk about risk.  Out of the two positions, shorting a stock is infinitely riskier.  If the stock price falls to zero in a long position, the loss is limited to the total amount invested. For example, if I purchase $1,000 of XYZ company stock and XYZ company goes bankrupt. My *only* loss is $1000. However, in a short position, if the stock price increases, the amount of loss is infinite because the investor can lose more money than the borrowed shares are worth.  How? Because a stock’s price theoretically has no ceiling on its price. For example, a speculative investor decides that a stock trading at $20 per share will drop to $5 per share.  They would borrow shares at $20, but if the stock goes up to $60 per share, the speculative investor would lose $40 per share.  

Two Short Squeezes in One Month

GameStop is the “world’s largest video game retailer,” with approximately 5,500 stores in fourteen (14) countries. The retailer’s sales have struggled as video gamers moved their game purchases online over the last few years. However, when the coronavirus pandemic moved millions of people indoors in March 2020, video games kept people entertained.  In March 2020, video game sales exceeded $1.6 billion, which was the “highest reported spend for a March” since 2008. GameStop became a pandemic princess going from $4.37 per share on March 13, 2020, to $18.84 per share on December 31, 2020. 

But no one was convinced that the good times for GameStop would continue. Especially not Ryan Cohen, who most notably is the co-founder of Chewy.com. Cohen is considered a master of the online space and saw that the brick-and-mortar retailer was missing out on an opportunity.

As a 9.98% owner of the company, Cohen wrote a letter to the Board of Directors in November 2020, where he stated that the Company was in a “long-term secular decline,” as evidenced by the 85% decline in the stock price over the past five years. He said that the decline was a direct result of the Company’s unwillingness to “pivot with urgency and grow with gamers.” Cohen noted that GameStop was “one of the most shorted stocks in the entire market” because investors lacked confidence in the “current leadership team’s approach.”

The first GameStop short squeeze happened on January 13, 2021. In a short position, the risk is that something, anything— earnings, good news, Reddit — can cause the stock price to go up. Two days prior, Ryan Cohen was offered a seat on the Board of Directors of GameStop. Investors started buying into GameStop because Cohen’s addition to the Board was envisioned as a clear path for the struggling retailer to grow online based on his success with Chewy. Increased optimism in a company’s position is a nightmare for a short-seller.

In a short squeeze, when a shorted stock price drastically increases, short-sellers have to act quickly to cover their position to limit their losses. In these cases, short-sellers are said to have been “squeezed out of their positions.” The rush to buy shares increases the stock price even more. By the end of the January 13th trading day, there was an x20 increase in trading volume, increasing the share price by almost $11 per share.

But that wasn’t it for short-sellers. The second, massive, short squeeze was triggered from an unlikely place, r/wallstreetbets, a Reddit community from which before it was closed boasted more than 4 million members. In this forum, investors were encouraged to drive up the stock price by buying GameStop’s shares, or going long, and purchasing call options. The short squeeze increased GameStop’s stock price from $39.12 on January 20, 2021, to a high of nearly $483 per share on January 28, 2021, and causing large losses for short-sellers.

It has been reported that short-sellers had losses of more than $5 billion so far. After the Hedge Fund Melvin Capital closed out its short position, it was reported that major hedge funds Citadel and Point72 infused close to $3 billion into the company to secure its finances.

We’ve Seen This Before With…

In October 2008, when Volkswagen seemed poised for bankruptcy, short positions made sense.  In an interesting turn of events, Porsche announced on Sunday, October 26, 2008, that it held stock and options that controlled 74% of VW. Porsche stated that they had “decided to make this announcement after it became clear that there are by far more short positions in the market than expected.” 

One day in October 2008, in the middle of the biggest financial crisis since the Great Depression, Volkswagen became the world’s most valuable company. As a result of a short squeeze.

 efore the financial crisis, Volkswagen had been struggling financially and was heavy in debt. Combined with a decline in demand for new cars due to the crisis, it seemed that Volkswagen was headed for financial ruin.  However, its share price was elevated because VW was faring better than expected during the recession. With unstainable performance and an inflated stock price, VW was an attractive short candidate.

It is important to note that this announcement was made on a Sunday, which offered short-sellers very little time to close their short positions. It is rumored that Porsche made over $10 billion from the squeeze. However, it is rumored that hedge funds that shorted VW stock amassed losses three times that amount.  

What Should Individual Investors Do?

In 2018, when Tilray stock was involved in a short squeeze, its CEO, Brenden Kennedy, said, “Keep it all in perspective as these very unusual market dynamics are taking place.” That’s great advice. Investors need to watch, listen, and learn and stay away from speculative positions. Trying to get in now is equivalent to trying to catch a falling knife. To close the loop on VW, the share price fell significantly after the squeeze.

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