What Is A Short-Selling Squeeze

"Depending on to whom you listen, the recent GameStop "short squeeze" affair will have little to no impact on long-term investors, or… it will change everything."-Eric Coons

If you saw the film The Big Short, starring Christian Bale, then you have undoubtedly heard of the standard Wall Street practice of "short selling." While there are a few ways individuals can short a stock, short selling is mainly a technique used by larger institutional investors, such as hedge funds.

Short selling involves predicting whether a particular company or market will lose value or even fail. A seller borrows a specific number of shares from a holder in a short sale, promising to return the shares on a specific date. After borrowing the shares, the short seller sells them off immediately, at the current market rate. Say a stock was worth $9 per share and then fell to $5 per share, the short seller would get $4 when they purchase those shares to return to the original holder. If the company fails, the short seller gets the entire $9 per share. Short selling is common, and some argue necessary stock market practice. However, it's precarious. If the price of a share happens to go up, the short seller faces nearly infinite risk.

The "Squeeze" Is On

When a stock suddenly stops its downward trajectory and jumps sharply higher, short-sellers who had bet on that stock to fall are forced to buy it. The pressure and rush to buy contribute to the stock's prices going even higher.

We are currently seeing the effects of this in a series of short squeezes occurring on various stocks, most notably, AMC Holdings, Inc. and GameStop Corp.  In January 2021, individual retail traders on a social medium forum known as Reddit orchestrated a short squeeze to drive up AMC, GameStop, and other stocks' prices.

As a result of the price spikes, short-sellers scrambled to cover their short positions to avoid potentially catastrophic losses. This rush to cover losses is known as a "short squeeze."

The GameStop/AMC short squeeze you've seen in the news lately has caused several large hedge funds to incur losses in the billions of dollars.

Effects of the Gamestop short squeeze

Many people view GameStop's recent events and the stock trading service Robinhood as a kind of populist uprising. There may indeed be "elements of sticking it to the Big Boys" involved. There is also the allure of an individual investor being able to generate massive amounts of profit.

Many financial experts maintain that because the short squeeze and its effects were limited to a handful of smaller companies, there will not be much of an impact on long term investments and retirement accounts. While the short squeeze incident is indeed a significant event, it probably won't impact retirees that much as it will day traders and retail investors.

Retirees and pre-retirees who practice proper asset allocation among diverse investment choices and protect their cash with safe money strategies are less likely to be impacted by wild market gyrations. Partnering with a seasoned financial advisor will help you ensure that your investments have the reliable performance metrics needed to weather market downturns and meet your long-term goals. However, the short squeeze saga raises numerous critical questions, genies that won't go quickly back into the box.

For example, social media and finance platforms' use to manipulate markets and users will bear further examination. There are also questions about the legality of everything that happened during the recent series of short squeezes. It's a pretty sure bet that we'll see tons of lawsuits and responses from regulatory agencies. On the philosophical side, the media attention surrounding short selling may result in discussions about how to democratize Wall Street better and make it easier for individuals to share in the massive wealth.

The bottom line:

Most long-term investors won't be affected by the goings-on with Robinhood and GameStop since those short squeezes involved relatively tiny amounts of stock in very small companies. While it is easy to demonize, short selling is a crucial component of Wall Street, acting as a signal that investors believe a stock's price is too high. It's just like when stocks are bought, signaling that investors think prices are too low.

For most retirees who have been careful in crafting their portfolios, the recent goings-on with GameStop will have virtually no impact on their accounts. That being said, it's a good idea to review your portfolio often with your trusted advisor to ensure that it continues to reflect your risk tolerance, goals, and investing philosophy.