Squeeze Them Dry

After a few years of writing and talking about financial markets, you start to realize that most of what you speak about causes involuntary narcolepsy in roughly 90% of people. Ramblings about central bank policies and economic indicators aren’t exactly edge of your seat stuff for most sane individuals.

However, every now and then, a crazy event happens that perks the interest of even the most avid market skeptic. Over the past two weeks, one such event occurred. Finances answer to David vs Goliath, if you will. David, in this case, took the form of Reddit retail traders, who banded together to punish Wall Street speculators for betting against GameStop, a previously unloved video game retailer. GameStop shares surged from $19 at the start of the year to as much as $483 in the process.

The tale begins deep in the online forums as chatter circulates about GameStop’s extraordinarily high ‘short interest’. This means a large portion of investors had borrowed shares from brokers and sold them in the market with the expectation that the price would fall. This drop in price would allow them to repurchase the shares at the lower price, return them to the broker and then pocket the difference.

The very high ‘short interest’ and low trading volumes in GameStop meant that retail traders could, if enough of them bought into the premise, push the share price higher. This would force the investors who were ‘short’, into buying GameStop stocks to limit their losses. Remember, these short-sellers only borrowed the stock, so if the stock price increases, the short seller would have to go to the open market and buy whatever shares are available to close out their position or fill their margin calls. This is how the now infamous ‘short squeeze’ works.

So as long as Reddit’s band of merry men (and women) could push the stock price high enough to force a ‘short squeeze’, the huge ‘short interest’ in the stock would ensure that the ‘short squeeze’ would push the stock substantially higher. A vicious self-fulfilling stock surge cycle, driven by the very individual who had bet against it. Ingenious, right?

Before going any further, let me state for the record that the ill intentions of the short seller is something that has always irked me, so the recent siege on Wall Street’s bottom feeders brought me tremendous joy. However, my overwhelming thought is that this will not end well for most retail traders.

Like most things in life, there’s a catch. The problem with short squeezing occurs after you have done it. Once you squeeze the shorts dry, how do you get your money out? It’s imperative that you are not the one left holding the bag. (At the time of writing this, the stock has dropped almost 70% in less than 48 hours).

Another important point to recognize is, while a small portion of reasonably unimportant hedge funds crashed, it doesn’t mean that all (or even most) large Wall Street firms are losing. In fact, some of them are making a fortune from all this. The high-frequency traders and market makers of the world are having a field day with sky-high volumes, manic volatility and new traders entering the market, traders who pay little attention to spreads, order routing or trading times. This is where these firms make all their money. While the ‘us against them’ and ‘stick it to the man’ narrative ensured the storyline achieved instantaneous virality, In reality, most of the rich got richer, while many of FOMO traders got caught in the crossfire.

Finally, there is a more sinister element to all this is, that also has me worried for retail traders. Wall Street doesn’t always play by the rules. Historically speaking, there has been a recurring theme of big institutions changing the rules of the game if and when they start to lose. We saw this in 1923 in the form of Clarence Saunders and his solo attempt to corner Wall street. In 2007/08 Wall Street unsuccessfully attempted to bend the rules at the expense of Michael Burry (the Big Short) as mortgage-backed securities started to tank, and just last week this tendency reared its ugly head once again as discount brokers ceased trading on the most heavily shorted stocks, citing the need to ‘help traders stay informed’. The same brokers who offer mindless options leverage to anyone and everyone are suddenly troubled by your financial education? Call me a cynic, but I find it rather coincidental that this overwhelming need for investors to stay fully informed happens just as their biggest customers (hedge funds) are hemorrhaging losses. Following significant backlash, Robinhood later changed their story, citing ‘instruction from their clearing house’ a far more legitimate excuse no doubt, but the damage was done.

I’m not about to sit here and tell you not to get involved. Neither me, nor any of these discount brokers are in a position to determine the level of risk that you are comfortable with.  The best we can do for now, is highlight the risks involved, helping you make the most informed decision possible. After that, it’s up to you.

What I will say is, please understand that this is trading, not investing and adjust your approach accordingly. Both are valid strategies for making money, but the approach to each needs to be vastly different. Investing requires taking a long-term view, while trades, like short squeezes, burn brightly, then flame out and are more akin to outright gambling. If you fancy your chances, please proceed with caution and only invest an amount that you are comfortable to lose.

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