What is a “short squeeze”? - Kakiforex.com - Financial Market Media No. 1 in the World What is a “short squeeze”? What is a “short squeeze”?
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August 9, 2021

What is a “short squeeze”?

 Being out-of-favour and heavily “shorted” are key characteristics of so-called meme stocks. But what does being “shorted” mean, how does the “squeeze” work, and how have individual investors turned this to their advantage against hedge funds? Read on to discover retail investors’ new “meme squeeze” investment strategy, how they bested complacent hedge funds, and how this cat-and-mouse contest between hedge funds and retail investors is continuing.


How a short squeeze works

A short squeeze is when a stock’s share price rises (often pushed by retail investor buying), forcing investors (usually hedge funds) who had been positioned for the stock to fall, to have to reverse course and buy the stock, in turn, driving the stock up even more. This has been a major characteristic of the meme stock rallies seen this year. There are two stages to a short squeeze — the “short” position and then the “squeeze.” 


The short position is when investors, often hedge funds, position for a company’s share price to fall. They do this by borrowing a company’s shares from long-term shareholders, such as pension funds or insurance companies, with an agreement to return the shares in the future. In the meantime, they hope the company shares will fall, allowing them to return the shares to the owner, and to pocket the share price difference for themselves. Meme stocks were popular “shorts” as they are often struggling or trying to implement a turnaround plan, with these weak fundamentals attracting hedge fund short sellers.

The squeeze comes when rather than falling, the share price actually rises. This rise is often driven by retail investor buying, which forces the hedge fund to go into the market and buy back the shares it needs to return to the underlying owner (“short covering”). The more the share price rises, the stronger this pressure (the “short squeeze”). The hedge fund actually contributes to this share price rise by being an additional buyer in the market. The larger the short position, the more shares that need to be bought back, and the greater the risk if prices do start to rise.

The “meme squeeze” explained

Retail investors have taken advantage of this situation to develop their own “meme squeeze” investment strategy, by galvanising the huge online investor community to force up the share prices of heavily shorted companies, triggering a short squeeze against hedge funds and further price gains. This has added a third unique ingredient to the traditional “short squeeze” strategy.


The “meme squeeze” evolved from the dramatic rise of retail investors, fusing their traditional focus on small cap and growth stocks with an embrace of the online investor community. This saw the development of their own “meme squeeze” investment strategy which sees online interest focusing on buying a small cap stock with a large short-interest position, in the hope of driving a “short squeeze” and a big short-covering stock rally. 

The Gamestop example

Where hedge fund complacency met the retail revolution


Video game retailer GameStop (GME) is the most famous example of this new investment strategy. The chain was well known by consumers, given its 5,500 retail stores across the malls and high streets of the US, Canada, Europe and Australia. But it was seeing increased competition as the industry transformed to an online ecommerce model. This made the company unprofitable between 2017–2020, and saw its share price fall to an April 2020 low of under $3 a share, down from over $25 a share only three years prior, and putting its market capitalisation well below $1 billion. 


With such a seemingly poor fundamental outlook, many hedge funds were positioned for the share price to keep falling. The size of these short positions was enormous, with the number of shorted shares famously more than all the company’s outstanding shares. The so-called “short interest ratio,” or shares shorted as a percent of total company shares, was over 100%. This huge short position was equal to over six days of GameStop total average daily trading volume. This is called the “days-to-cover” ratio. The size of this position was unprecedented and reflected hedge funds’ complacency that nothing would stop the share price continuing to fall.


However, in late 2020, GameStop became popular within the online retail investor community, including on sites such as r/wallstreetbets, and their buying started to push the share price up. This forced the hedge funds to buy shares in the market to cover their huge short positions, and helped drive the shares from under $20 to nearly $350 by the end of January 2021.


Pressure on the hedge fund shorts

The success of this meme squeeze strategy has seen hedge fund losses* estimated at US$12 billion, with hedge fund Melvin Capital losing half its value in January, London-based White Capital announcing its closure, and famed short-report writer Citron Research withdrawing from the strategy.


This has only added to the significant existing pressure on the “short” community of hedge funds from the continued equity rally. It is difficult to bet on lower stock prices when the market as a whole is rallying strongly. 


It is estimated that S&P 500 short positions are now equal to only 1.5% of total market capitalisation. This is a twenty-five-year low level, and less than half the global financial crisis peak level of 3.5%. It also illustrates how extreme the hedge fund short position in GME was at over 100% of shares. 


More broadly, we have seen only 177 short reports (negative research reports published by investors that short a company stock) and 182 shareholder activism campaigns (investors looking for significant changes in company strategy and management) last year. These each represent a tiny 0.6% of the total number of global listed equities.


An evolving cat-and-mouse strategy

This meme squeeze investment strategy continues to develop, as both sides adapt. For those remaining short-focused hedge funds, the complacency is over, and they have been forced to take smaller short positions, with greater diversification across more stocks, and with a close tracking of retail investor sentiment. For retail investors, more stocks are now being targeted, and discussions are taking place on a broader range of social channels.


The current meme stock rally comes with less extreme, but still high, short levels. For example the GME short interest ratio and days to cover now represent a fraction of its January levels, but are still well above market average levels. In addition, many more stocks are now involved than the original handful back in January.


The cat-and-mouse game between hedge funds and retail investors is continuing and evolving. Watch this space.