What You Need to Know About Short-Selling and the Stock Market

Short squeezes like what we saw this year with GameStop aren't new. But the evolution of the communication between investors and the trading platforms used to mobilize around the stock are--at least to the investing world.

Since the early days of the Internet, message boards have long been used by individuals to tout their investment positions. However, the exponential growth in social media coupled with the advent of easy-to-use, no-commission trading platforms enabled a crescendo that sent GameStop’s stock price soaring twenty-four-fold, before it came crashing back down.

But what does it all mean? Morningstar’s John Rekenthaler has already addressed whether shorting stocks should be illegal. Here, we explore the potential implications events like these have on the markets and what investors should know.

First, Is the Stock Market Broken?

No. The surge and subsequent plunge in GameStop GME stock shows that the market is working as intended. Numerous short squeezes have happened in the market over time. But none have had any detrimental impact to the market over the long term.

To the angst of many individual traders, several brokerages temporarily restricted their ability to purchase more shares during the height of the short squeeze. The move sparked outrage among these investors who were trying to push the stock price to ever higher heights and some politicians who questioned the fairness of such trading restrictions.

But the restrictions were the result of the capital requirement rules in place to protect market integrity. If a broker were to fail before outstanding trades could be settled, it could lead to much wider and severe market disruptions.

Brokerage firms are required to post capital as collateral to cover counter-party risk. As the value and volatility of these outstanding trades increase, the amount of required capital increases significantly. If between the trade date and settlement date a broker were to go bankrupt, the broker might not have the financial wherewithal to pay for the shares at settlement. If that were to occur, it could cause a much larger disruption to the marketplace if investors lost confidence that they would receive their capital when they sold stock.

If enough investors were to lose confidence in the ability of brokers to honor their purchase, similar to a run on the bank, many investors might then look to sell stock and cash out before others.

How Often Do Short Squeezes Happen?

Short squeezes are relatively uncommon, but not rare, events.

In the U.S. equity market, squeezes most often occur in small-cap stocks, defined as companies worth less than a $1 billion, where many investors have a negative view for the prospects of the business but the short interest ratio has risen too high and has become a “crowded trade.”

A few higher profile examples include:

Hertz in 2020. Herbalife in 2012.

Is It Always a Small Company?

No, just one in which a confluence of technical factors all line up at the right time. In 2008, Volkswagen temporarily became the most valuable company in the world during a short squeeze on its shares.

But Why Do People Short Stocks?

There are many motivations for short-selling. For example,

• Equity traders and market makers in options and futures may short stock in order to hedge their positions.
• Arbitrage investors may use short positions against long positions in the expectation that a spread differential between the two will contract.
• Fundamental investors may short a stock if they think it is overvalued and with the intent of repurchasing it at a lower price at a later date.

What Made the GameStop Short Squeeze Different?

It was crowdsourced online.

This may be the first example of individual investors using a social-media platform to formulate and communicate a trading idea directly with one another and then crowdsourcing a short squeeze.

It drove the stock price into the stratosphere.

In just two weeks, the stock price had surged to 24 times higher than where the stock had been trading prior to the beginning of the short squeeze. That’s a much higher increase than typical short squeezes. There was such a high short interest ratio and a deluge of retail buying that the stock price ran up so fast the shorts hardly had time to cover their positions at reasonable prices and then they did everything they could to hold off on covering their short positions until the price began to crack.

This Short Squeeze Seemed Like a Big Deal. Was It?

Not really.

While there will likely be other instances in which individual traders will try to band together to push asset prices higher, it’s doubtful that we will see other situations that will rise to the same level of enthusiasm.

If there’s an increase in rapid-fire trading targeted by these crowdsourced groups, it could lead to increased short-term volatility for those stocks. Still, even if there is an increase in volatility in some individual stocks, this event will not meaningfully change the fundamental basis of investing or the market structure, especially for long-term investors.

What Does This Mean for Short-Selling in the Future?

Investors who short stocks will be much more cautious and will shy away from piling onto already crowded short positions. Short investors will also need to monitor social media, and, when positions begin to move against them, they'll either quickly cover their shorts or look to hedge their positions.

In addition, a number of companies that have seen their stock prices appreciate rapidly have used the opportunity to issue stock at attractive levels. This action helps to offset the short squeeze as it will take an even greater amount of new purchases to push the stock price even higher and provides more float for the shorts to cover their positions.

What Should People Look for When Investing in Stocks?

As oft attributed to Benjamin Graham, the father of value investing, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” While short-term technical factors can and do influence the price of a stock over the short term, the value of businesses are generally much more stable over time. In our view, owning a stock is equivalent to owning a piece of the business.

We recommend investing in those companies with long-term, sustainable competitive advantages, or economic moats, that trade at a discount to their intrinsic value.