Short Squeezing

The financial news this last week has been dominated by the short squeeze activities in stocks such as GameStop, AMC Entertainment, Bed Bath & Beyond, and Blackberry. Retail investors are aggressively buying options on these and other stocks which have been shorted in large volume by hedge fund managers. It’s billed as a David versus Goliath phenomenon.

To such a degree that when on-line brokers such as Robinhood limited trading in GameStop, there was an outcry by left-wing congresswoman Alexandria Ocasio Cortez and conservative senator Ted Cruz alike, perhaps the first time they have agreed on anything[i].

The play is to target stocks that have the highest short interest (i.e., stocks with the highest volume of shares borrowed, expressing the view that the stocks will fall in value) and buying call options to bid up the price[ii].

When one is long a stock, or an option for that matter, the most one can lose is one’s capital invested. However, if one is short a stock and it moves against you, the potential loss is unlimited. Short sellers who were short AMC Entertainment Tuesday evening at just under $5 suddenly were down four-times their investment when the stock popped to $20.34 at the Wednesday morning open.[iii]

To avoid this, short sellers may have had to cover their positions by buying back the stock, at a big loss – this is the classic short squeeze. And some retail investors have made good money “squeezing out” institutional short sellers – at least on paper.

What we are seeing today are irresponsible actions by retail investors on sites such as Reddit who use commission-free online options trading. Usually when one gets something for free, one ignores the real price.

It is bound to end badly. Firstly, some of the highly shorted companies are in bad shape, and in the end could go bankrupt. So, there is still plenty of money to lose when things calm down. The problem today is that some retail option traders are simply in it for the game and do not care about how much they win or lose. It’s just another form of corona-induced home entertainment – like gambling.

More concerning is the risk to the financial system. Robinhood, the commission-free trading platform, had to borrow and raise capital to ensure facilitation of trade clearing activities. Once again, we are reminded of the cliche that there is no such thing as a free lunch.

This also extends to some passive index products which include some of the highly volatile names, and experienced large outflows last week. That is why we prefer rules-based ETF’s that can rebalance or pare back bubble stocks.

This is not a time to trade options. Volatility is too high, and this factor makes option prices expensive.

One of the best pieces of advice I ever heard from a wise investor, is to never confuse an investment with a trade. An investment has a long-term time horizon, and one should hold it as long as its investment thesis remains intact. Trades have a finite life – and when a stock trades up for whatever reason beyond one’s target price, it’s time to take profits. And that time may be now.

Norman H. Chait, CFA

Managing Principal, Nardis Advisors LLC, January 31st, 2021