GME: A Lesson In How A Short Squeeze Works

If you watch financial news, you are probably aware of the short squeeze initiated by retail traders that drove share prices of stocks like GameStop Corp. (GME) up more than 800% in a few days. It was the biggest story last week. I do not think the news reporters did a very good job explaining the mechanics of a short squeeze and why the stock price gains, in this case, were so extreme.

Going over the basics of short selling stocks and how that can go wrong will show you why it went so very wrong this time. (And also so very right for those who owned shares of GME.)

Selling stock short is a way to profit from when a share price drops. To sell short, a trader must borrow shares from his broker to sell. The goal is to buy back the sold-short, borrowed shares at a lower price, profiting by the amount the stock price fell from when it was sold short. If the stock price goes up, the short seller loses money on the trade.

Here are a couple of considerations about selling short. The strategy is widely used by hedge funds, especially those with a long-short strategy. Part of a portfolio will be in long investments, and part will be short, hoping to profit from both sides. Hedge funds typically use significant leverage or borrowed money to make the trades.

With a short sell trade, the max profit occurs if the stock goes to zero. So shorting GME at $10 per share gives a max gain of that $10. Potential losses from a rising stock price are theoretically unlimited. When GME zoomed to almost $500 per share, theory became a reality.

A final point on short selling: as I already mentioned, the trade requires borrowing shares from a broker. I saw news that 140% of the GME float had been sold short. It should not be possible for more than 100% to be shorted, and because brokers can lend only shares held in margin accounts, the percentage of shares available to short should be much lower than 100%. In the case of GME, it appears brokers for hedge fund traders lent shares they didn’t have. I think the subsequent trading halts were a way to prevent this illegal activity from coming into the light.

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