GameStop soars following Reddit bulls forcing short sellers to cover. Let’s take a look at what’s going on and how it’s impacting even broader markets and diversified portfolios like Ursa. No Ursa account yet? Download Ursa here!

TLDR: Short squeeze occurs when increasing stock prices force short sellers to buy shares compounding rising share price. Market not immune to impact from bad stock rotation, reducing short risk, stock bubble fears and uncertainty.

What is a short squeeze?

To start, what is “short”? Shorting a stock is basically the opposite of buying it (aka going long 😜 ) …you’re selling it. However, since you don’t have any shares to sell, you’ll need to borrow shares from someone else to sell. The idea is you can buy it back at a lower price later and give the share back to who you borrowed it from.

ELI5 example: I borrow your new PS5 and sell it for $1,000. Later, I buy another PS5 when they’re in stock for $500 and give yours back. I made $500 (sold yours for $1000, bought back for $500).

So what’s a short squeeze? Shorts are more risky because of unlimited risk involved. When you buy a stock and the price declines, most you can lose is what you paid. If you’re short and the price goes up, your loss is what the stock gained. However, you’re not capped at just your investment. If the stock goes up 100%, you’ve lost your entire investment. 😯 If the stock goes up 200%, you’ve lost twice your investment. 😳

With unlimited loss potential, investors are forced to either cover (buy shares to return to borrower) or add money to their investment. Often, investors aren’t looking to double down 🃏 and cover their shorts. This can have a compounding effect as it creates more buying activity which pushes the stock price up. So as short sellers cover their positions, prices go up and cause other short sellers to cover their positions. Hence, a short squeeze.

Sounds reasonable – what’s the fuss about? Out of favor stocks tend to have more shares shorted as investors bet against the stock doing well. In fact, GameStop essentially had ALL of its shares borrowed for shorting at the start of the month. This setup was ripe to potentially take advantage of. You just needed enough money (or in this case a lot of people cumulatively with money). The Reddit message board r/wallstreetbets initially recruited its community to begin the short squeeze, but media hype the last few days really compounded it. #ShortShorts

So what now? GameStop has traded 700M shares in the past 5 days-that’s 7 times its entire shares outstanding. Wednesday (today), the trading volume was less than half the volume earlier in the week. Most of the initial short sellers are likely covered by now. They may reestablish their short positions again, but likely at lower volumes with less shares. It’s turning into a speculative bubble. How much higher can it go before people call it and send the stock crashing down? 🧐

So why would this impact the market?

🧐 Rotation into “Bad Stocks“?

There was a lot of money behind the GameStop shorts. Investor losses are estimated in $5B to $10B range. That money had to come from somewhere. To cover losses, hedge funds likely had to sell from other positions likely “Good Stocks”. Basically flipping the market around selling “Good Stocks” they wanted to be invested in and buying “Bad Stocks” they wanted to sell/short. Also, just like buying creates a short squeeze, selling can be contagious too… 🤧

😰 Reduced Exposure to Shorts

GameStop, AMC and a few others already got Reddit’s attention. Who’s next? We’d expect firms to reduce short exposure across the board just in case. We potentially saw it this week in Ursa portfolios with Lumen ($LUMN) up +40% this week on no news. However, $LUMN doesn’t have a huge short position.

😱 Stock Bubble Fears

Investors were already nervous coming into the year. Stocks at all-time highs in middle of a devastating pandemic. Not just prices, valuations stretched with recovery already priced in. We believe surge in retail investors helped prop up valuations. But what now? Are we going to see more irrational #YOLOMoney speculating on out of favor stocks instead of actual investments? The market isn’t supposed to be a casino. We feel this might accelerate a #Flight2Safety.

😬 Uncertainty

The market hates uncertainty. This market environment is feeling a bit uncharted-which equals uncertainty. What now? A lot of things may or may not happen. SEC stepping in with more regulation on retail trading especially around options? Higher risk premiums on options? Does Reddit investors try shorting companies next?

Especially given the uncertainty, we feel confident in our diversified portfolio approach. We’re monitoring events unfolding closely and could see our #Flight2Safety thesis accelerate.

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As of the publish date of this article, Ursa portfolios may own LUMN. Ursa portfolios do not own GME or AMC. These stocks mentioned in this article may cease to be owned by Ursa portfolios at any point. This article is the opinion of the author. Anything within this article should NOT be considered an investment recommendation or advice. See Ursa’s full disclosures here.