Short Squeeze? What the Heck Is That?

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.

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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. 

Margin Loans

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.

Why Borrow?

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.

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Investing vs. Speculating

Investing vs. Speculating

Today we are going to talk about the difference between investing and speculating.  

We have all heard about GameStop and some of the other companies. There were meteoric rises, significant drops, and prices went right back up. There is a lot of speculating and manipulation going on with this company. At the end of the week, it caused some extra volatility in the stock market.

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We want to cover a couple of different things today. First, let’s talk about the difference between investing and speculating.

Investing vs. Speculating

Investing is a long-term process that we use to build wealth over time.

Speculating is a short term bet to pursue a big payoff.

Investing —if you avoid key mistakes, and ride through some of the setbacks—has a high probability of success over long periods of time.

Speculating has a high probability of failure. But a big return potential.

Investing is a boring, uneventful process—most of the time. There are periods of absolute terror, like last spring.

Speculating is an adrenaline-pumping game. It is exciting and exhilarating.

Most of us want to be investors and pursue the long-term accumulation of wealth. It is fine to speculate from time to time. But understand you could lose everything you bet very quickly.

If you make big bets trying to time your entry points in and out of something like GameStop, you have a low chance of doing it well. You may have some temporary success, but at some point, things are going to go against you. Things can get very ugly before you have a chance to react.

If you want to be a speculator, go for it. Keep your bets small and only bet what you can afford to lose.

Anxiety in the Stock Market

These events are causing some temporary anxiety for the stock market. But there are big differences in what’s going on with these few companies and what most people try to do. The trading activity in companies like GameStop does not decrease the value of the other great businesses.

We’ve seen many temporary setbacks over the past 100 years. This may be another one.  For investors who own shares of good companies, stick with it, and don’t panic, things tend to work in their favor.

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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.

Our Most Recent Videos And Posts