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Investors are simple people. We buy a share for the long term, hoping it will move higher and we’ll profit off dividends and the share price move.
We also have a limited 100% downside risk (if the company we’re invested in were to go bust) and unlimited upside reward.
Traders, on the other hand – while they buy and sell the same stocks as investors – have a totally different experience.
They will hold for much shorter periods of time; for some it’s as little as a few minutes or hours, or it might extend to a few weeks or months.
They will also use gearing – essentially borrowing money to buy more of the share they’re trading – and this juices their profits, but also their losses.
But another important, and big difference, is that traders will also short a stock. Shorting is trying to profit from a downside move.
It basically entails selling what they don’t own; they have to borrow the stock in order to sell it – a process most trading platforms will automate.
Once a trader sells the stock, they will hope to buy it back at a lower price, with the difference being the profit they then make. However, the risk-reward pay-off here is very different.
As the lowest a stock can go is zero, a trader’s return is capped at 100%, but if the stock soars, there is the chance of losing more than 100%.
This then brings us to a situation called a short squeeze. This happens when the number of short positions on a particular stock is large, and something starts to push the share price higher.
That something could be a rumour, results or a broker upgrade – anything that starts a stock moving higher.
This then causes some who are short to exit their position, which they do by buying. This adds extra buying pressure and pushes the price even higher, causing more short positions to exit.
If there are enough short positions, this can really snowball and create a surge in the price, resulting in a short squeeze as the short traders are being squeezed out and frantically heading for the exit.
A famous example of this was back in October 2008 when German automaker Volkswagen for a short period became the largest company in the world due to a massive short squeeze.
The squeeze started when Porsche announced they had bought 74% of Volkswagen shares while another 20% was held by the state of Lower Saxony, meaning only 6% of issued shares were tradable.
Yet short sellers had borrowed around 13% of Volkswagen shares to sell.
The news from Porsche created speculation of a possible delisting and the short traders were desperate to exit, sending Volkswagen stock up from around €200 to over €1 000 in two days.
More recently, Tesla stock also saw a massive short squeeze after solid results ramped up the price from $440 to almost $1 000. Locally, Steinhoff is another stock with a massive amount of short positions; rumours that they could sell Pep Europe for perhaps as much as €4.5bn saw the share price gallop from 82c to over 200c in a matter of days.
Now, the ultimate conclusion of any short squeeze is that the price always comes back down over time – usually within a few days or weeks – and the short positions are squeezed out and normal market activity resumes.
Tesla is back below $750 and Steinhoff is under 150c.
Short traders wanting to hold on during the squeeze need deep pockets and a strong constitution. The cash is for the margin calls. Remember, traders often use borrowed money.
The losses soon eclipse the cash they started with, lenders will want more and more cash as the trade goes deeper and deeper into a loss.
And things can get hairy: The price may not come back quickly enough, leaving a trader with a massive loss that well exceeds their initial deposit.
This article originally appeared in the 20 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
