This is the first of a three part series on the recent short selling drama caused by traders on the subreddit Wallstreetbets. First, we cover the short squeeze, a classic play.
All that anyone could talk about at the end of January was the rapid rise in GameStop’s stock price. This struggling retailer saw its market capitalization grow to extraordinary heights to the tune of some $20 billion. Company fundamentals do not support anything close to that valuation, but for a moment, it happened.
GameStop (along with AMC and Bed, Bath & Beyond) took off like a rocket ship due to a simple imbalance between supply and demand. It’s economics 101. When there is little supply and strong demand, prices will rise to a level until buyers won’t pay any longer.
The classic short squeeze … on steroids
Why on earth would supply suddenly become constrained and demand whipped up for a dying retail name? The hedge funds that were shorting GameStop and betting on its continued decline were the target of a classic short squeeze. The Wallstreetbets traders decided to buy up stock, forcing short sellers to cover their position (aka, buy stock), which created demand. Potential buyers saw this happening and jumped on board, knowing the hedge funds would eventually have to buy GameStop at higher price levels.
The traders on Wallstreetbets were wildly bullish, and not for a fundamental reason. They knew how to work the system. People who don’t trade for a living thought this was an anomaly, but the short squeeze is quite common. We just don’t hear about it.
The GameStop story captured our attention, because it appeared to be a David (individual traders) v. Goliath (billion dollar hedge funds) story. It pitted good versus evil, the little guy versus billionaires. But in reality, a short squeeze is not a bad thing. If a trader sees an imbalance between demand and supply, the trade is fair game.
As we saw with GameStop, the timing of a short squeeze is critical. Once the word got out to buy these shares, it was game on. But now it appears the game is over.
The shorts squeeze is a classic move that will continue. Just don’t bet that these massive hedge fund managers will lose sleep over it.
Next week, we will talk about how short selling is a healthy and normal part of trading.