Meme Stocks and Breaking Down Short Squeezes

Backdrop:


Meme stocks and Reddit’s Wall Street Bets have been behind some massive, short squeezes thus far in 2021. GameStop (GME) and AMC Entertainment (AMC) have been the most notable battleground stocks between the hedge fund managers and retail traders. Hedge fund managers that have short positions on a stock profit when the stock declines. Retail traders on the other hand identify heavily shorted stocks and buy the stock with the intention to short squeeze these hedge funds and cause a dramatic rise in the stock price. Although this tug-a-war has worked for GME and AMC in the short term, deploying this tactic can be dangerous. These short squeezes result in astronomical stock appreciation, extreme valuation distortion and liquidity issues as trading can be halted when trading abnormalities are triggered. Here, I’ll breakdown the anatomy of a short position and the mechanics behind a short squeeze.

What’s A Short Position?


Short positions are taken by those that believe the company is overvalued and are taking the position that the stock will decline in value over the near term. Essentially, this is betting that the stock will decline and when the stock falls, the short position is profitable. Short positions are taken by borrowing shares and then selling the shares in the hope to subsequently buy back the shares at a lower price to capture the spread. For example, shares are borrowed and sold at $100 and over the near term, the shares fall to $75. Once these shares fall as expected, the short seller can then buy these shares back at $75 and return the borrowed shares while netting $25 per share in the process.


Short Squeeze:


A short squeeze occurs when the short position does not materialize (i.e. fall in price). A short squeeze situation is most likely to occur when the stock is heavily shorted (high percentage of the float is shorted). When the demand for the stock is high and being purchased with large inflows, this results in rising share prices. The rise in the share price is in contrast to the short positions and hence the short positions now have unrealized losses. In order to prevent further losses from occurring, these short positions need to be closed out in order to return the borrowed shares. In order to do this, shares must be purchased by the short position holders. This results in removal of the short interest and negative drag on the stock and more demand at higher prices as shorts are buying and buying as the stock rises to cover their position. This culminates into an astronomical rise in share prices as the massive, short squeeze unfolds.


Fallout:


The short squeeze success has been isolated to a few stocks however attempts with several other heavily shorted stocks have not been fruitful. These short squeezes are typically short lived and those that remain in their positions may be hurt long term. Meteoritic rises in stock prices is due to an anomaly, a short squeeze in this case. This results in stock prices that are discordant with reality and divorced from the fundamentals. Not to mention extremely distorted valuations that are in danger of coming back in-line with historical trends.


Conclusion:


Meme stocks have been all the rage over the last few months as the retail investor takes it to the hedge funds that have massive, short positions on stocks like GME and AMC. Although this tug-a-war has worked for GME and AMC in the short term, deploying this tactic can be dangerous. These short squeezes result in astronomical stock appreciation, extreme valuation distortion and liquidity issues as trading can be halted when trading abnormalities are triggered. When a short squeeze occurs, shares are purchased by the short position holders. This results in removal of the short interest and negative drag on the stock and creates more demand at higher prices as shorts are buying and buying as the stock rises to cover their position. This culminates into an astronomical rise in share prices. Short squeezes result in stock prices that are discordant with reality and divorced from the fundamentals with extremely distorted valuations that are in danger of coming back in-line with historical trends. As fun as this is to watch from the sidelines, participants beware of radical stock movements and dangers associated with these stocks.


Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY and USO. However he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial adviser or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of Stock Options Dad, LLC - www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.


Originally published in partnership with INO.com https://www.ino.com/blog/2021/06/meme-stocks-and-breaking-down-short-squeezes/#.YPNnOuhKhPY

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