New Blog
This blog post first appeared first on old medium publication (https://medium.com/startuprad-io), and was moved to this blog with the relaunch of our website in summer 2024.
In this blog post, we explain short selling, what a short squeeze is and how this all led to a shitstorm for the Berlin-based fintech Trade Republic
Disclaimer
The author has no positions in the discussed stocks. The personal opinion of the author is that any retail investor should stay away from any such crowded trades. These markets can be really tricky and quantitative traders could buy and sell any share multiple times, in a time span, any human being needs to only press a button.
Tune in to our Internet Radio Station here:
Subscribe Here
Find all options to subscribe to our newsletter, podcast, YouTube channel or listen to our internet radio station here:
Our Sponsor Startupraven
The best way to identify investors and cooperation partners for early-stage startups. Sign up for early access here:
Short Selling
Many seem to get short-selling wrong, so let us first take one minute to elaborate on this. Going long means in capital markets speech to buy a stock. Going short therefore means selling a stock.
Not every investor (especially professional investors like funds, banks, or insurance companies) needs to actually own the stock they sell, they can borrow it for example from a pension fund. The pension fund will get a fee and if the long-term investment rationale of the pension fund is correct, the stock will pick up again after the short sale.
Types of Short Selling
Hedging: Not every short selling is for speculative reasons. There are several cases (especially for banks or funds hedging) to sell stocks short and limit their risk. This usually has to do with the derivative positions of the entity. We won’t discuss this here, anyone interested in it can surely use Google :-).
Speculation: Finally the speculative short selling. An investor (e.g. a hedge fund) borrows shares from a pension fund, sells the shares, pays the fee, and hands the shares back to the original investor. Keep in mind the part where the short seller needs to give back the shares, this will be of importance. Note also that not only bad Hegefunds are selling short, but also EU domiciled so-called UCTIS funds can do that (aka 130/30 funds), also in the US so-called Bear Mutual Funds. Normally one would have a Long/Short fund or a Short only hedge fund in mind when talking about speculative short selling.
How Short Selling Works
We will simplify this, but bear with me here:
We assume you are a hedge fund and think that company Z will publish results below the analyst’s expectations, which will lead to a decline in their share price.
So, you ask your prime broker to help you borrow shares from a pension fund.
You have to post collateral — called margin — at the prime broker, who arranges the deal.
You get 1.000 shares of company Z, which are currently trading at a price of 100 Euros.
You go on and sell these shares over a few days, earning 100.000 Euros. We assume here, that 1.000 shares will have an impact on the price, with investors abandoning company Z, and selling their shares due to the bad results published.
The share price of company Z declines and stabilizes at 85 Euros a share.
You buy back the 1.000 shares, spending 85.000 Euros
You earned 100.000 Euros and spent 85.000 Euros on buying back the shares.
So you made 15.000 Euros, before fees for securities lending, margin costs, and brokerage fees. This is how speculative short sellers make a profit.
Short Squeeze
A short squeeze happens when a short seller does not find enough shares to hand them back to their owner. So we assume again company Z only has 10.000 shares. Of these shares, 70.000 are held by strategic investors and are not available. This leaves us with the rest, the free float, 30.000 shares. These are the shares that regularly change hands on one or more stock exchanges.
Now we assume many of these remaining investors don’t want to sell, or simply there are more buyers than sellers in the market (like when many investors agree on Reddit to buy the same stock) driving up the prices. This is the point, where the short position of the hedge fund is under pressure or “squeezed.”
The hedge fund sold the Z-shares to potential long-term investors. Since the hedge fund does not get the 1.000 shares to fulfill its contractual obligation at the current market price of 85 €, they need to offer more for each share. If they don’t hand the shares back, as agreed in the lending agreement, the fund would need to pay a fine. So the fund keeps offering more money.
At 100 €/share only 100 investors will sell — the price to which the hedge fund originally sold the shares. The hedge fund only has 90.000 € left in this “position” and the prices are still going up with breathtaking speed since more Reddit Investors are joining in.
Now, at 120€/share, 500 investors will sell. This leaves the hedge fund with only 30.000 € of its proceeds from the short sale.
And another 400 investors will sell at 150 €. This is again 60.000 €. This leaves the hedge fund with a loss of 30.000 € from this position, plus interest on the lending of the securities, plus potentially additional collateral at the prime broker, and of course any additional fees.
Since not enough willing sellers were available the hedge fund had to incur a loss of approx 30% on this trade. Since hedge funds can be leveraged to a significant amount, one can see that not many trades can incur such losses, without endangering the fund itself.
A short squeeze is not as uncommon as one would think. The last time something like this happened was when Porsche tried to buy VW, rocketing the share price by 80% during that trading day in 2008. During that squeeze hedge funds reportedly lost 30 billion US$.
GameStop
The topic came to prominence recently since the shares in GameStop — a brick and mortar retailer for video games and merchandise — had a significant short interest (meaning many investors sold the stock short), but again there were no willing sellers on the other side and so the prices went up, at one point in time +1.700%.
As of writing this blog post (February 1st, 2021) Bloomberg reports that the short interest (shares lent out to short sellers) is plummeting from 114% in mid-January to 39% beginning of February. It seems that this time the small guys have won. This also leads to a 34% drop in the share price of GameStop.
Here is also a good video wrap-up of the story by The Economist:
Silver, AMC, and Silver
It appears that the success of GameStop activities has given some momentum to the Reddit Trader Community. Currently, they are pursuing other shares as well as Silver. Please note again that the author warns again, against joining any such positions.
The Other Side May Lose Billions
It may take a significant amount of time (maybe even an SEC investigation) to really learn who was one of the short-sellers, but it appears that the Wall Street Journal has already identified the hedge fund Melvin Capital: https://www.wsj.com/articles/melvin-capital-lost-53-in-january-hurt-by-gamestop-and-other-bets-11612103117. They won’t be the only one showing losses. According to data provider Ortex, from Friday, January 29th, short sellers were sitting on 19 bn US$ of losses in GameStop alone. This changed a bit with the move on Monday, February first, but still amounts to 13 bn US$ losses.
A Snapshot of Short Interest
If you are curious now, here is a list of the largest short interest positions as of January 15th, 2021 in the US, including Snap Chat parent Snap, ride-hailing company Lyft, Beyond Meat, Palantir Technologies, Snowflake, Peleton Interactive, Door Dash, Expedia, Seagate Technology and Sirius XM amongst others.
Trade Republic’s Shit Storm
The German fintech Trade Republic is one of the most prominent fintechs in Berlin at the moment.
They follow a similar model as Robin Hood in the US.
During the height of the trading, they suffered several service disruptions. The app was down for some time. A spokesperson explained to Business Insider Germany that there have been technical problems at LS Exchange, which lead to a change to the trading venue Tradegate, but Tradegate also had technical difficulties. During the height of the trading in GameStop, Trade Republic suspended the trading with the GameStop shares, as well as later with AMC Entertainment, BlackBerry, Bed Bath and Beyond, and Nokia.
All these shares have been hot topics on Reddit. This led to a shitstorm on social media and some blog posts like this, talking about patronizing investors.
Note also that other brokers in Germany like Scalable Capital or Flatex did not suspend any trading in these shares.
The day after, Trade Republic had to say “We are sorry” in an email to their clients (Friday, January 29th). It is yet unclear if and what implications this may have for this fintech in the future. Maybe they just shrug it off, maybe there are lawsuits coming from investors. We will keep you updated.
111