Investor behavior is fascinating, and this week the markets have produced a series of occurrences that will go down in history. A small handful of companies unveiled what can happen when things didn't go as planned. A great deal of wealth was created for some and lost by others.
Our Chief Market Technician, Andrew Thrasher, CMT, explains what happened. “A short squeeze occurs when the price of the stock you need to repurchase to return to the rightful owner rises to a point where you cannot bear the pain any longer. You are financially forced into submission along with everyone who also shorted the stock. Suddenly there is a race to repurchase the shares, and what you considered a dog can suddenly appear to be the princess of Wall Street. Looking at the markets this week and wondering why some stocks were up more than 50% – welcome to the short squeeze.”
Adam Harter, CFA, and our Chief Investment Officer adds, “Short squeezes are some of the best evidence that market movements are often chunky and not smooth. It's great to understand that external forces can enter quickly, seemingly from left field. And sometimes your exit from a position may be out of your control.”
There are reasons to allow stocks to be sold short. The act helps finance Wall Street. When company XYZ is purchased in a brokerage account, the custodian can lend those shares to other investors. The borrowers pay interest to the custodian – not the actual owner of the shares – and then the borrower sells the shares and gets the current share price added to their account.
There is a concept called a pairs trade that requires shorting a stock or index. The idea is that you pick out two investments and put them head to head. For instance, you buy one technology company and sell another. You don't have to own the stock you are trading. You borrow it from the custodian at a price.
The person shorting the stock believes that they are more insightful than the current owner. The seller does have to return the shares they sold. The hope is that they will repurchase them at a lower price, keep the profit, pay the custodian their fee and enjoy their earnings. Sometimes that works out marvelously, while other times, it ends in panic.
“Covering” the trade occurs when the shares are eventually repurchased. The position is closed out at the current price. A stock sold short going up by multiple percentage points a day is financially devastating.
Shorting does not happen in a vacuum or black hole. The number of shares outstanding shares is available, and so are the number of shares currently sold short. Occasionally, when the percentage of shares sold short reaches a certain percentage of all available shares, sudden turmoil can occur. The “squeeze” can drive companies with potentially poor fundamentals to rise in value as those who are short the stock repurchase the shares.
Joseph A. Clark is a Certified Financial Planner and Managing Partner of The Financial Enhancement Group, and an SEC Registered Investment Advisor. Contact Joe at yourlifeafterwork.com or 800-928-4001. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.
World Equity Group, Inc. does not provide tax advice. For tax advice consult with a qualified tax professional.