First, it’s important to understand supply and demand and that when demand for a stock increases, usually so does its price. Moreover, what we’ve seen over the past week is a number of day traders working together, through social forums, to purchase significant amounts of stock shares in specific companies in an effort to drive up the stock price. On the other side, you have Hedge Fund managers who have bought these same stocks on short sale with the belief that the price of these shares would go down with hopes of capitalizing financially on these potential declines. So you have two different types of investors with competing goals and strategies, let’s break down how this all works.
So I am going to explain a few terms and show some examples of how this can happen. Let’s start by talking about what it means to short sale a stock. When you short sale a stock you are borrowing, a stock you don’t own for up to 90 days, and immediately selling it. You’re hoping to scoop the stock up at a lower price and profit the difference. For instance, a hedge fund in this case, is expecting the stock of a certain company to fall in the coming months. Let’s say a stock is currently worth $20 per share. They expect it to fall to under $10 per share. So, what they do is use a pool of money or “Margin” to borrow the stock and then sell shares at the current the price with the hope of buying the sold shares at a later date for a reduced price and returning the borrowed shares to the owner and keeping the profit. Here is an example of this.
Company A is currently valued at $30 per share on Jan. 28th. Investor X borrows and sells 1000 shares of Company A that he doesn’t currently own. So he must have $30,000 of Margin to execute this trade. On March 20th, Company A is now trading at $10 per share. Investor X then purchases 1000 shares of Company A at the current price of $10 per share and then returns the shares, that he borrowed, to the owner; thus retaining the profit of $20 per share, which is a total gain of $20,000.
Now the risk involved in a short sale is unlimited. The reason for this, is the stock price could move up an unknown amount. So in our last example. Let’s say that the share price for Company A moves up from $30 per share on Jan. 28th when Investor X short sold the stock and now on March 20th the price per share is $50. Now investor X must buy 1000 shares at $50 per share thus creating a $20,000 loss in order to return the shares he originally borrowed. Because of the volatile nature of a short sale this is not a service available through OFS Financial Services or Cetera.
A short squeeze can result when there is a rapid increase in the price of a stock primarily due to technical market factors like those described above, rather than underlying business fundamentals. In addition, with a short squeeze there is a lack of supply and excess demand because hedge fund investors who hold a large amount of stock in a short position must cover their positions by purchasing large volumes of stock relative to the market volume. By covering these positions, it means they must buy shares, thus the short squeeze causes a further rise in the stock’s price as more shares are being bought. In some cases, this could then trigger other additional margin calls with other investors that have also shorted the stock who now also have to purchase stock; thus creating an even more rapid escalation in the stock price.
In essence, what we could see happening is a hedge fund could be shorting a particular stock and a group of individual investors could be purchasing this stock to drive up the stock price and thus creating a short squeeze on the hedge funds that have decided to short sale. Many people have asked me, how long can these artificial prices can stay inflated before they correct themselves? And, I like to respond with quote I once heard someone say, which is “the market can usually stay irrational longer than you can stay solvent.” In essence, it’s tough to predict how these situations will play out, but it’s always good to have an understanding of how different parts of the market work.
I hope you found this quick tutorial helpful and if you have any questions, please don’t hesitate to contact me.
These examples are hypothetical only, and do not represent the actual performance of any particular investments. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and when sold or redeemed, you may receive more or less than originally invested.
Securities and insurance products are offered through Cetera Investment Services LLC (doing insurance business in CA as CFG STC Insurance Agency LLC), member FINRA/SIPC. Advisory services are offered through Cetera Investment Advisers LLC. Neither firm is affiliated with the financial institution where investment services are offered. Advisory services are only offered by Investment Adviser Representatives. Investments are: *Not FDIC/NCUSIF insured *May lose value *Not financial institution guaranteed *Not a deposit *Not insured by any federal government agency.