Important Info You Need to Know About Short Squeezes

by Options Sensei |

The tale of Gamestop’s (GME) quickly becoming legendary with its stock surging over 180% to an intraday high of $159 prior to settling back at $76 per share — gaining over 260% in the past three weeks. 

This is also a cautionary tale as sophisticated traders suffer large losses by taking the other side or shorting the stock, believing it won’t keep rising. The first two quick lessons are: 

1) Stocks can go up to infinity, maybe not indefinitely, but there’s no price too high on a temporary basis. 

2) Never (and I mean never) expose yourself to unlimited losses! 

To better grasp how GME, a video game retailer that was on the bankruptcy brink just six months ago, can gain some $6 billion in market cap in mere days, we need a short primer on short selling and the nature of options’ gamma.  In a somewhat concerted effort, the two combined to create a potent force driving stock prices to seemingly irrational, if not impossible levels. 

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In short selling, an investor borrows a stock, sells it, and then buys it back to return it to the lender. Short-sellers bet that the stock they sell will drop in price.  The sell price and the buy price difference is the profit.

GME always had a large short interest over the years with investors predicting the company’s demise.  However, about three months ago, it rose above 100% of the float and hitting as high as 160% two weeks ago, meaning more shares were sold short than were available.  This occurs due to firms lending out shares on multiple occasions.  

Of course, if the stock starts moving higher, short-sellers may have to buy it back for more than they sold it for, resulting in a loss.  The higher the price goes, the larger the loss. Short-sellers are embedded buyers — having to eventually buy the shares to close the position (sometimes forcibly through a margin call) – or a loss could take more capital than they had in the account.  This can create self-fulling with buying, begetting more buying, leading to what’s known as a “short squeeze.”  

Shorting stocks will always be attractive to a certain type of trader because when they’re right, it can produce legendary trades and huge profits.  Sometimes, it’s company-specific like Enron or Worldcom.  On occasion, entire sectors like the or housing bubble.  It’s usually done by professionals with market dynamics knowledge with them typically employing a form of hedging to minimize losses. 

Over the last few months, retail traders have taken the squeeze dynamic to control prices into an almost straight move higher.  Unlike most short squeezes — which seemingly develop naturally, groups of retail traders through chat rooms like WallStreetBets, make concerted and targeted attacks on stocks with large short interest.  This article from Bloomberg does a nice job of explaining what’s been occurring. 

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In addition to GME, other stocks whose businesses have been stumbly such as movie theater chain AMC or Bed Bath and Beyond (BBBY), have seen their shares soar as Robinhood and WallStreetBets band together in a sort of flash mob to overwhelm the shorts and force a squeeze. 

In doing so, some have made huge profits while others have sustained large losses.  One hedge fund, Melvin Capital, was down some $1.7 billion on its GME short, only to get an injection of another $2.7 billion, using it to avoid a forced margin call or liquidation and adding to its short position through an out-of-the-money call options sale. 

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Retail traders saw this action and started buying “Out Of The Money” (OTM) calls, creating more upward pressure on the stock price through what’s known as gamma.  

To explain the market dynamic, let’s drill down into the definition and mechanics of what an options Gamma is:  

Gamma is a second derivative, measuring how much your delta will change per unit change in price.   In other words, as prices rise your delta increases.  Or more pertinently, as prices decline your delta turns more negative, with you getting longer as prices go up, and shorter as prices decline.  Sometimes, people confuse gamma with vega which is a measure of volatility. They sometimes act in concert but aren’t related; kind of like country and western.  I have no idea what that means, but you get the gist.

If you’re short gamma (net short options and hence volatility), one usually has to take a defensive stance on large moves, putting them at high risk of compounding losses and setting off a self-fulling bout of ever-increasing volatility — becoming more tempting for bears or shorts to sell. 

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This creates another sort of feedback loop.  The combination of a stock short squeeze with negative gamma has led to some of these eye-popping moves. 

Stocks with short interest of over 10% of the float are up an average of 40% in just the first three weeks of 2021.  The 30 stocks with the highest short interest are up 75% this year. 

But, if you’re contemplating jumping onto one of these rocket ship short squeezes, be aware that they can crash as quickly as they rose, leading to large losses for those that bought it at artificially-high prices. 

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