There are undoubtedly new market forces at play now for GameStop Corp (NYSE:GME) stock. The short squeeze has existed for as long as it has been.
What exactly is a Short Squeeze?
How does the short squeeze work? If traders believe a stock’s price will decline, they can short it. They borrow shares and sell them to repurchase them at a reduced price.
Given the dangers and margin requirements, institutional investors, such as hedge funds, are the predominant participants.
And there are significant risks involved. Theoretically, the price of stocks may increase indefinitely. Therefore, a short trader can incur infinite losses.
Some stocks attract high short interest, which can be regarded as the number of shares sold short as a proportion of the float, or the total number of shares issued and available for trade.
The issue arises if stock prices begin to rise abruptly. Short sellers of the stock will probably face a margin call. Either they must put up more money to secure their position or lose their investments.
They will purchase shares if they wish to or are compelled to close their position. This can drive the price and force other short sellers to follow suit. This produces a self-reinforcing cycle of purchasing and price inflation. This is the short squeeze, wherein market shorts are “squeezed” out.
Short Squeeze Stocks: GameStop Corp
This is undoubtedly a component of what was occurring with GameStop Corp (NYSE:GME) shares. In August of 2020, GME stock traded for around 4.
As a result of notable investors acquiring holdings in the company, the stock price rose gradually to close out 2020 just below 20. This attracted short sellers and considerable hedge funds. Then, on January 13, 2021, the stock soared to nearly $40 on heavy trading volume.
That was undoubtedly the beginning of the tight squeeze. This 40 level lasted approximately one week. On January 22, the stock rose again, trading above 70 on the day with the highest volume to that moment.
The following day, the stock reached over 160, with similar activity. Then, on January 27, the share price quadrupled again, reaching 380. The high on January 28 was 483.
Although short squeezes are not novel, this move is unprecedented. Wallstreetbets, a Reddit group, is undoubtedly involved in some of the action.
While many applauded the fact that small retail traders defeated large institutional shorts, it is evident that other institutions also participated in this purchase. Elon Musk tweeted about Michael Burry’s gains on GameStop Corp (NYSE:GME) stock, which have been the subject of news articles.
Hedge Fund Losses
In this squeeze, there were considerable losses. Two funds were particularly affected. According to reports, Citron Research and Melvin Capital have experienced enormous losses.
Short squeezes are typically initiated by one hedge fund against another.
This is the first time a group of retail traders has initiated such trading.
Options Trading Is Likewise A Major Factor
A significant portion of the activity in GameStop Corp (NYSE:GME) and other companies such as AMC Entertainment (AMC) and BlackBerry (BB) was taking place on the options market.
Buying bullish call options instead of purchasing the underlying stock is advantageous due to the leverage and reduced risk involved.
Calls are contracts granting the buyer the right to purchase the underlying stock at a specified price (strike price) until the contract expires. The amount that can be lost is the call premium.
Buying calls involves substantially less capital, allowing small traders to take more extensive holdings. This enhances the effect of the short squeeze. When regular traders purchase options, market makers are the ones who sell them. Market makers engage in delta hedging to avoid the danger of being short calls.
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