Recently the rapid price increase in a small number of stocks has caught the attention of the national media as well as investors from small retail to large institutions. The swift upward movement in those stocks revolved around the process of shorting stocks and the subsequent “short squeeze”. The stock movements left many fascinated and puzzled by the volatile price action.
To decipher these events, first, we must know what “going short” refers to and why investors would choose to short stocks. Shorting refers to a trading strategy that profits from the DECLINE in price of a stock. Technically an investor borrows shares of a stock from their broker and sells them in hopes of buying back in the future at a lower price.
The below information provides a simplified version of the shorting process:
Here are a few potential reasons investors may want to short a stock
- They believe the company is flawed or has a broken business model
- To hedge downside risk
- To profit in a bearish market
The recent meteoric moves in Gamestop (GME) and AMC Entertainment (AMC) occurred in part because these stocks each had a high level of short interest. Institutional investors, primarily hedge funds, held large short positions in these stocks believing there was a disconnect between the stock price and the underlying fundamentals of the companies. They believed the price of the stocks would be lower in the future and built large short positions to profit when these stocks declined.
What happened next was unexpected and somewhat unprecedented. A group of individuals on social media, Reddit, banded together to exchange trading ideas to buy the stocks with high short interest. Their purchases pushed the stock prices higher and, because these shares are borrowed, many short positions had to be liquidated quickly and caused the prices to rise even higher. This is what is referred to as a “short squeeze”. At some point, the rapid price rise ends as short positions are eliminated or individuals buying these stocks begin to sell their positions. This rapid price increase can also revert quickly, as traders take profits or short sellers re-enter the market, and those that bought at very high prices begin to sell to avoid further loss.
This pricing action, while it can be interesting to see and garners much attention, is not what we would call investing. These actions are taken without any semblance of fundamental analysis or measurement of valuation. It is simply a short-term speculation transaction based on a trader’s belief they can find someone to purchase the asset at a higher price later, with their only rationale being the current price action.
While these actions can be profitable for a few, for many participants this type of speculation ends in loss and frustration. This type of trading is not in conjunction with the investing that Gradient Investments does on behalf of its clients. Our focus is to be active managers, but we manage based on long term opportunities using fundamental analysis like the state of the economy, the health of companies in the economy, and the valuation of companies within our investable universe. Further, we use a holistic approach to build sound investment plans for the purpose of achieving an investor’s pre-defined objectives within the bounds of their risk tolerance. We believe this is a method that has proven successful over the long term and is the best way to achieve your financial goals.