Short Squeeze? What the Heck is That?
What the heck is a “short squeeze”? With the recent activity in GameStop, clients have been asking about this.
Watch Now: Short Squeeze? What the Heck is That?
Buy Low-Sell High
To understand this, we have to start with the most basic premise of investing, “buy low, sell high.” When investing, most people buy the investment first and hope it appreciates in value. Then you can sell it for a profit.
Short sellers have the same objective, but they do transactions in reverse. They sell at a high price with the hope of buying the stock at a lower price in the future. In a short sale, you normally don’t sell a stock you already own. Instead, you borrow the shares from somebody and sell them.
In the investment industry, these are margin loans. A margin loan requires capital up front to start the transaction. In some cases, that might be 50%. If you’re going to sell $10,000 worth of stock short, you have to have $5,000 cash in the account.
There is also a maintenance requirement. This is the amount of capital you must keep based on what happens with the share price of the stock that you sold. For some firms, the maintenance requirement is 30%.
Here is what happens if the stock price goes up suddenly like GameStop did. Our $100 stock goes to $200. Now you owe $20,000. Your maintenance requirement is 30%, but you only have $5,000 in the account—or 25%. This triggers a margin call, which means you must meet the maintenance requirement.
Borrowing creates leverage which can enhance your returns. It can also enhance your losses. Here is an example. You short sell 100 shares of a stock trading at $100 for $10,000. The stock price falls to $80 and you buy the shares. You made $2,000 on this transaction. Because you used leverage, your rate of return on this transaction is 40% ($2,000 profit divided by $5,000 capital).
What Happens When You Receive a Margin Call? The Short Squeeze
The short sellers can add cash to their trading accounts. But many companies do not have extra cash to add to their accounts. Many individuals will not have a lot of extra cash either. This forces short sellers to either buy the stock at a higher price or sell other positions to cover the margin call. This is the short squeeze.
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About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.