Shorting, Short Squeezes, and the Story of GameStop

Feb 13, 2021 | How does shorting a stock work for swing traders?

How does shorting a stock work for swing traders?

January 2021 will be a month not soon forgotten by Wall Street. With the meteoric run of GameStop and other heavily ‘shorted’ stocks, we thought now was a great time to dive into the principles of shorting stocks and how it can impact prices in the market. As the stay-at-home economy continues, thousands of new traders have flooded the market. Many of whom have no understanding of the basic fundamentals needed to maintain long term success in stock trading. It’s easy to hear buzz words and see quick gains, but it’s imperative a trader fully understands the fundamentals of what’s happening when a stock is being shorted. 

How Does a Stock Get Shorted?

       
  1. When someone is shorting a stock, they believe the price of that stock will go down over time. 
  2.    
  3. The trader will then come to an agreement with a broker and a time frame is established. 
  4.    
  5. The broker or lender will then allow the trader to borrow shares of the underlying stock with the agreement that the shares must be returned within the agreed upon timeframe, with interest.
  6.    
  7. Once the contract is established, the trader, (who may also be referred to as a short seller) immediately sells their shares of the borrowed stock to another investor within the market.
  8.    
  9.  The original trader hopes they can eventually buy those shares back at a much lower price then they sold. Thus, capitalizing on the variance in price change.

Key Principles When Shorting Stocks

       
  • The trade always begins with a sell
  •    
  • The trade is NOT completed until all borrowed shares have been reported back to the lender 
  •    
  • The trader whose shorting the stock hopes to buy back the shares they sold at a steep discount to profit the difference 

Shorting is a Contrarian Move 

It’s important to understand that by nature, shorting a stock is considered an extremely contrarian strategy. If you’ve ever been at a craps table in a casino, it’s like placing a ‘don’t pass bet’. The person placing that bet is essentially rooting against everyone at the table. Shorting a stock takes a very similar mindset. Over the last twenty years, the stock market has averaged returns of anywhere between 6% - 8%. Shorting a stock is taking a hard stance that a company’s stock price will break that trend and not rise over time. 

Why Do People Short Stocks? 

A stock may be shorted for several reasons including:

       
  1. A short seller believes there is a fundamental problem within the underlying business
  2.    
  3. There’s a perception that a stock price is overvalued 
  4.    
  5. There  is potential for upcoming news that could negatively send the stock price down 
  6.    
  7. The company is engaging in illegal activity or fraud  

Above all else, shorting stock involves rooting for the underlying company or business to fail. 

Weekly Swing Trades

Stock 2

December 18, 2022

Entry Price:

74.20

Stop Price:

72.65

Target Price:

77.20

Time Frame:

3 Week Hold

Caught a key support level last week. Monitor your 5 & 9 day moving average to ensure we don't lose momentum for this swing trade. Full info for our premium members.

Stock 1

December 18, 2022

Entry Price:

118.09

Stop Price:

114.24

Target Price:

125.08

Time Frame:

4 Week Hold

Classic moving average play here, looking for support off the 50 day MA. Closing last week, there was a slight uptick. If momentum holds, should make for a nice swing trade. Full info for our premium members.

Is Shorting Risky?

Shorting stocks is extremely risky! So much so, many brokerages don’t allow the retail investor to engage in these types of transactions. There’s certainly no guarantees a stock’s price will go down and simply not shoot up unexpectedly. 

A sudden jump in a stock’s price might occur if:

       
  • Higher than expected earnings are reported
  •    
  • Unexpected news is received favorably by the market
  •    
  • Or as we saw from GameStop, pure FOMO  

If a stock’s share price goes above and beyond the price the short seller originally sold for, there’s potentially no limit to the losses a trader might incur! When you invest, all you can lose is the money you invested. When short selling, your losses can be limitless.  

Remember: The trade is not complete until the short seller buys back the borrowed shares and then returns them to the original lender, plus any added interest. This process is called covering or closing your position. 

When Does a Short Squeeze Happen? 

As we’ve noted throughout, when shorting a stock, the trade begins with a sell and ends with a buy. Since shorting is a technique most likely implored by hedge funds, volume can quickly become a critical factor. Hedge funds trade shares in massive quantities. Therefore, it doesn’t take a large price movement in either direction for an institution to immediately feel the impact within their own portfolios. 

A Short Squeeze Will Occur When:
       
  • Multiple institutions are buying back shares of a soaring stock to close their position and limit their losses 
  •    
  • As the stock price rises higher, more institutions will inevitably be forced to close their position and to cover their positions
  •    
  • This results in more buying and massive volume which may send the stock price even higher still! 

As the stock price continues to ascend, more traders will be forced into closing their short positions. Then momentum has kicked in and so has the FOMO. The fear of missing out becomes very real and the general public starts looking for that golden goose. Now they’re piling in and the price can go even higher! 

Caution: If you’re trading a heavily shorted stock, ensure you properly understand the risk involved and please utilize proper stop loss strategies. As you can see, it doesn’t take much for a short squeeze to become a snowball. With rapid buying and massive volume, this can cause a huge change in a stock’s price and then as they say, the squeeze is on!

How Can You Tell if a Stock is Being Shorted?

A key measurement to review when tracking short selling is called the short interest ratio (SIR).

Short Interest Ratio:
       
  • A numerical value that is calculated by dividing the number of shares that are short by the stock’s average trading volume
  •    
  • Low trading volume and a high ratio of shorted shares will equal a high SIR
  •    
  • Stocks with a high SIR can be very susceptible to short squeezes 

SIR can also be used to estimate how many days it would take for those who are shorting the stock to close and cover the position. 

Remember: A short squeeze can occur when there’s a heavy volume of buying which can rapidly push the share price up. During these times of high volatility, it can be difficult for a hedge fund to close the position and limit their losses given the rapid change in a stock’s price. 

What Happened With the GameStop Short Squeeze?

Now that we all have a good understanding of what's really happening during a short squeeze, let's take a look back at GameStop and review how it all played out.

       GameStop (GME) 1 Hour Chart

December 8, 2020: GameStop reported earnings lower than expected and the stock dropped from $16 a share to $13 on the news. After yet-another quarter of declining sales and a dying business, GameStop had become a prime target for short sellers.  

January 11, 2021: GameStop hired new Directors including the Co-Founder of eCommerce powerhouse Chewy. Stock price jumps 50% on this positive news all the way up to $31 a share. A share price not seen from GameStop in years. 

January 19, 2021: As the run of GameStop starts to become mainstream news, a major research firm calls GameStop traders "suckers" and "fools at the poker table". This drives the volume buying up even higher as the chatroom frenzy begins to grow.

January 26, 2021: As the stock price continues to ascend, Elon Musk sends out another memorable tweet hyping "Gamestonk". This tweet, along with the entrance of more individual retail traders, sends the stock on a parabolic run.

January 27, 2021: GameStop is now the top news story. The headline is set- “the retail investors vs the hedge fund short sellers. 

Remember, as discussed previously, when a company shorts a stock they are only borrowing shares. So when the stock goes up astronomically, banks begin to margin call the short sellers. In order to cover their shorts, they have to buy back into the market- this increased buying only increases the price action.

January 28, 2021: Robinhood, the main brokerage for many retail investors, suspended the ability to buy shares of GameStop- this allowed for a cushioning period to take place. While trading was halted, the hedge funds had time to regroup and close their positions. 

While many news outlets ridiculed Robinhood for the decision, the company released the following: "We continuously monitor the markets and make changes where necessary. In light of recent volatility, we are restricting transactions for certain securities to position closing only."…"Amid significant market volatility, it's important as ever that we help customers stay informed."

From Robinhood’s prospective, the company had to meet capital requirements required by regulators and banks. This requirement, according to Robinhood, forced their hand. While the story may be far from over, the entire situation left a lot retail investors with a bad taste in their mouth. The volatility in $GME has now subsided and trading has again reopened.

 

Summary

Shorting stocks can be very lucrative, but it can also be extremely risky! So much so, the average trader may not even have access to a brokerage that allows shorting. Shorting requires a mindset that hopes for a business to fail which goes against historical trends within the stock market. With that said, a good trader is always learning and looking for ways to capitalize on current conditions. Areal trader understands the only way to build long-term wealth is through consistent gains over time. But that doesn’t mean we can’t also profit over the sudden surge in a stock’s price when you have a responsible plan. As always, due your due diligence!

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Market Performance- Week of 12.18.2022

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BLDR (Builders Firstsource)

BLDR (Builders Firstsource)

Entry Price:

62.30

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Price at High:

70.00

Return for Members:

11.00%

Timeline:

3 Week Hold

Simple moving average play here. Anticipating a 3-4 week swing trade as momentum has been growing for a move up.

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Price at High:

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1 Week Hold

FMC has been on a bull run over the last month. As Swing Traders, we'll look to take advantage of the momentum and get in for a quick trade. Wait for a brief pull-back before entering.

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