The surge in GameStop has caught the market’s attention, and that of financial media. A small retail stock, in an industry in long-term decline, has seen its market value rise very rapidly, as retail traders, coordinating via the website Reddit, have bought into the stock using options, forcing the hedge funds that have taken short positions in it to close out their trades, pushing the stock yet higher.
What is a short squeeze?
This short squeeze is a classic market move, familiar to many traders, and is something that can occur in almost any market, if the conditions are right. In this, the conditions were that short positions had been built up in a company that had seen its stock price fall nearly 95% from its 2013 high. This ‘one-way’ trade had continued regardless of the moves in broader indices, as investors took advantage of the fall in traditional retail volumes, leaving companies like GameStop with declining businesses.
All seemed to work well, until traders on the ‘Wall Street bets’ sub-Reddit decided to start buying the stock. When the stock rises, some shorts have to cover their position by closing out and buying back the stock. This in turn drives the price higher, forcing out others, and so on. A short squeeze develops, which can, as in this case, drive the price to dizzying highs that are arguably entirely unconnected with the actual business.
Some might suggest this is market manipulation, but the short positions in a company are public knowledge, and it is not actually illegal for ordinary investors to club together in the same stocks. Traders who short need to be aware that such squeezes can happen and should also realise that the vast majority of trades, particularly in equities, are on the long side. Most investors, whether retail or professional, buy stocks in the hope that they will go up.
Shorting is an important part of the market and helps the activity of ‘price discovery’ to develop. It also helps liquidity and should be viewed as an underhand activity. But while share prices can ‘only’ go to zero, giving long investors a theoretical floor, they can, in theory, go as high as they like. Thus, those with short positions, can, if they do not manage their risk properly, suffer unlimited losses.
Continued gains are not guaranteed
While GameStop, and others that have been heavily shorted, has enjoyed a huge rally, this does not mean that continued gains are guaranteed. The future of any trade is always uncertain, and after such a huge ride there may be many investors, of all types, who still think that the shares are overvalued, and will look to short them once again. Regardless of whether an investor trades long or short, they must make sure that they have a clear risk management plan in place, with stop levels clearly defined.
We are currently seeing increased volatility in certain stocks, including GameStop and AMC. This increases the risk of sudden, large or rapid loss and the potential for gaps, where stocks fall dramatically when the market opens.
Please note that IG does not offer options on GameStop or AMC Entertainment, or the ability to short these stocksIt must be stressed that IG does not offer options on GameStop, with only spread bet, CFD trades or share dealing available on our platform.
The activity in these stocks has been confined to a small part of the market, with normal price action continuing in the vast majority of stocks. It will command plenty of attention in the media, and the excitement will undoubtedly provide an attraction for many traders, but sometimes it is better to watch from afar rather than attempt to jump in to such a volatile situation.