Shorting a Stock and a Short Squeeze 101 -
And Why Chatham Wealth Management Does Not Use These Strategies
In the past few weeks, the market has seen some incredible increases in the stock prices of some companies that are perceived as not having a good financial outlook, most notably, GameStop (GME). This is a stock that had been heavily shorted, causing a “short squeeze”. The article below provides an overview of the dynamics for shorting a stock. It will also explain what a short squeeze is, and what ultimately can happen in these scenarios.
Shorting a stock and trying to participate in a short squeeze is a risky strategy that Chatham Wealth Management never utilizes. Getting caught in a short squeeze can put an investment firm or client out of business, and we want to be here to work with you for the long haul!
In the past few weeks, the market has seen some incredible increases in the stock prices of some companies that are perceived as not having a good financial outlook, most notably, GameStop (GME). This is a stock that had been heavily shorted, causing a “short squeeze”. The article below provides an overview of the dynamics for shorting a stock. It will also explain what a short squeeze is, and what ultimately can happen in these scenarios.
Shorting a stock and trying to participate in a short squeeze is a risky strategy that Chatham Wealth Management never utilizes. Getting caught in a short squeeze can put an investment firm or client out of business, and we want to be here to work with you for the long haul!
What is “shorting a stock”?
When an investor has a negative view of a company, their expectation is that as the company’s business conditions deteriorate, the stock of that company will decline in price. The investor is able to make money on this prediction by borrowing the shares of the stock at a certain price, and selling them. This is called "shorting a stock".
The gamble is that the investor will be able to buy back the stock that they borrowed when the price of the stock declines. If the stock can be bought back at a lower price than it was sold at, a profit is made from the difference between the sell price and the buy price. i.e.…sell high and buy low.
So, let’s look at these steps …
How does an investor borrow stock?
From an investor’s standpoint, borrowing and shorting a stock is just about as easy as a regular buy or sale of a stock. The difference is that the investor is selling short the stock in a "margin account", which means that when they sell the stock they don’t own, they are receiving the cash from the sale of the stock they are borrowing into their margin account. They can use that cash to buy other securities. As with any borrowing, there is a cost (interest) involved.
What happens when the stock price declines?
The investor makes a profit! If one share of stock is shorted at $10 and bought back at $5 the investor has made a little less than $5 profit per share (less the interest). In this example, the maximum gain the investor can make is $10 per share - basically if the stock goes to $0 they make the $10. The stock can’t trade below $0.
What happens when the stock price increase?
The investor loses money! The big problem here is that the potential loss on a short position is unlimited. If the investor shorts one share of stock at $10, and the stock increases to $15 when it is bought back, the investor loses $5 per share (50%). BUT…what if the stock goes to $20, $50, and $100 per share? That is where the trouble arises. The investor has to buy the stock back at some point. Selling at $10 and buying back at $100 is a 900% loss! That is Very Painful…
Why not just hold the short until the price comes back down?
If the investor believes strongly that this is a bad company, then why not wait until the stock comes back down eventually? Going back to the borrowing mentioned earlier, the short investor is technically borrowing money from their broker when they initiate a short position. The broker has requirements for a minimum balance that the account needs to have in order for the investor to keep the short position. This value is called the "maintenance margin". If the stock rises, the value of the account declines, and if it declines below this minimum, it creates a "margin call" from the broker. The investor is informed that they need to either add more money to their account, or sell some other securities to make sure the account has the appropriate "maintenance margin". If no action is taken by the investor, the broker has the right to liquidate securities from their margin account. The broker wants to ensure there is enough money in the investor’s account so that they will be paid back the money they lent to the investor.
The “short squeeze”!!!!
Here is how this problem can multiply: The amount of a company’s shares that are short is public knowledge. It can be found on many financial related websites and services (Bloomberg, Reuters, etc.). It is expressed as a percent of the shares outstanding, i.e. 10%, 20%. In the case of GameStop, 140% of the shares outstanding were shorted!
Often times it would take multiple days of an average trading day’s volume for all the short portions to be covered. When a "short squeeze" happens, other investors are buying the stock, trying to run up the price of the stock to a point where the losses to the short investors are too painful, or a margin call happens, resulting in the short investors having to "cover their shorts", or buy the stock back, therefore pushing the stock price even higher! The investors causing the short squeeze make massive amounts of money in some cases on their long positions.
What happens next?
If the company really is in a structurally failing business resulting in financial distress, once the short positions are closed, there will be no way the valuation and negative outlook of the company can support a stock price that has increased 900% in a matter of weeks. Ultimately, the fundamentals will cause the stock to come back down drastically. The last investors to buy into the short squeeze after the stock that has run up can lose a ton of money.
The bottom line.
As tempting as it might be to get caught up in the hype of a stock that is going up like a rocket ship because of a short squeeze, we would recommend against participating. If you do decide to get on board so that you can talk about it at a socially-distanced dinner party, make sure you don’t invest more money than you can afford to lose!!! As far as shorting a stock, Chatham Wealth Management would strongly recommend staying away from this strategy. Do it at your own risk, because the results could be devastating.
If you have any questions or would like to talk about our portfolio management strategy and financial planning, please contact us at (973)635-4275 or visit us at chathamwealth.com. For more investment and financial planning related information, please click HERE to visit our blog.
Dan Moskowitz - CEO Brian McGeough – Relationship Manager John Lui – Chief Investment Strategist
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February 03, 2021 at 10:39PM
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Advice from Shorting a Stock and a Short Squeeze 101 - And Why Chatham Wealth Management Does Not Use These Strategies - TAPinto.net
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