The trading activity surrounding specific stocks, namely GameStop (ticker GME), triggered a lot of attention recently. The company’s price was pushed higher by retail traders acting in unison, with the intent to squeeze out major hedge funds positioned on the short side.
While this story is as old as Wall Street, the way things unfolded appeared to be from a movie script. The price of GME rose from below $20 to above $200, in an epic squeeze that made regulators intervene to halt the trading.
What is a short squeeze, and what exactly happened with GME?
What Triggered the Short Squeeze on GME Stock?
When investors choose to sell the stocks of a company or to go short, they expect the price to decline. The most they can make is 100% of their investment. Say, if the price of GME was $20 and the short-seller sells $20,000 shares, the most she can make is $400,000. That’s it. Thus, it is said that the winnings are bounded in the case of shorting stocks.
However, the loss is unbounded because the short-seller may lose more than the capital risked. If the price of the stock keeps rising and the short seller’s margin declines, at some point, she will be faced with the prospect of receiving a margin call. At that point, either the short seller will take a loss or will double down on the investment. Hence, on the risk.
As it appears on the list above, GameStop was a short-sellers’ darling. It made the top of the most-shorted stocks by hedge funds. One of those hedge funds, Melvin Capital, was forced to close its short position by a coordinated play organized on Reddit.
The outcome? In order to exit from a short position, the short-seller must buy stock to cover their shorts. Basically, to square the initial position. This is known as short-squeezing when shorts are forced to cover due to insufficient funds (margin).
In today’s financial world, things get even more complicated than a simple short-squeezing. A gamma squeeze creates an even more aggressive price action on the market because it involves options contracts that directly impact the underlying stock. An option is a derivative contract that depends on the underlying asset, in this case, the GME stock.
The gamma squeeze coupled with the classic short-squeeze led to retail traders kicking out a veteran hedge fund from a short position. It shows the extent and power that retail traders exert in the 21st century as the new generation of traders uses social media to act together as one.