Short Squeezes Are More Common Than You Think
Sure, You've Heard of Gamestop and AMC—But What About the Financial Crisis and the Auto Industry of the 1960s?
The classic problem with selling stocks short is that a stock can rise infinitely high but can only drop to zero, so the short seller's profit is capped at 100% while their losses are unbounded. And every professional short seller has the same response to this: "I've seen a lot more stocks go to zero than to infinity."1 Short sellers can more than compensate for that 100% profit cap with sheer volume of winning trades.
There is some truth to that argument, but there are other risks that short sellers take on: one of them being the risk of getting caught up in a short squeeze. If you’re not already familiar, short squeezes are a straightforward consequence of the mechanics of shorting, which work like this: the short seller borrows shares from a shareholder for a set amount of time (typically, though not always, this borrowing takes place continuously), and can sell them on the open market. The short seller might keep the cash and earn interest on it, partly offsetting the cost of borrowing shares, or they might invest that cash in something else. But since this is a loan (in the form of shares), they will have to pay back the shares at some point.
All of that is fairly straightforward. It starts to get complicated when we start to account for the fact that the number of shares available for borrowing is not constant: retail investors' shares are available for borrowing if they're in a margin account, i.e. an account that can borrow, but not if they're in a cash account. So customers can move their shares around to restrict them from getting borrowed. Or a single borrower can lock up a large supply of shares.
And when the supply of lendable shares suddenly dips below the demand to borrow them, a short squeeze happens. Short squeezes really occur on a continuum:
The most common form is that shorts get worried that the price will be driven by the supply/demand balance for shortable shares, rather than by company fundamentals, and they don't want to get caught on the wrong side of it. This worry is exacerbated by fund structure: pod shops have strict risk management, and if a team starts losing money they may be forced to shrink all of their positions, or even get liquidated. Short-focused funds tend to have looser risk rules, but for them a single bad position can be an existential risk.
A rare but particularly exciting occurrence is a "corner," where a single holder or a group of them end up owning more than 100% of the outstanding shares of a given company. This is entirely possible given the mechanics of short selling: if a company has 100 shares outstanding, and one shareholder owns 90 of them, lends out 50, and buys 20 of the shares that get lent out, that owner now has 110 of the 100 shares outstanding; if they call in their loan, the borrowers need to buy stock to pay them back, and there simply isn't enough to go around.
Corners are not what happened in 2021 with Gamestop and AMC, or with Tesla, or in most other cases where a popular short position skyrockets. But it has shown up a few times, though: the Panic of 1901 was precipitated by two railroad barons, James J. Hill and E. H. Harriman, who both tried to take over the Northern Pacific Railway. Their buying pushed the price up, short sellers sold, they both kept buying (as in many other M&A bidding wars, there was some combination of economic synergies and ego gratification at work), and as a result shares of the railroad went from $150 to $1,000 in a few weeks, liquidity in the market dried up, and other assets started falling. Hills' and Harriman's bankers stepped in to accept delayed delivery for short sellers' shares, and they negotiated a settlement.
There have been a few other corners and attempted corners, mostly in the early twentieth century when markets had developed enough for short sellers to sell a meaningful amount of stock, but not regulated enough for corners to be illegal.2 There was an attempted corner in shares of the Piggly Wiggly grocery store chain in 1923 (that one's perhaps most famous for being written up in Business Adventures), but from the mid-1920s onward, even before the SEC, there was a long fallow period for stock market corners. There were some attempted corners in other markets, like silver and copper. And Salomon got in trouble when a trader cornered a few issues of treasury bills.3
And then there was the biggest short squeeze of all time: a decade and a half ago, Porsche owned 44% of the shares of Volkswagen. The government of Lower Saxony owned another 20%, and index funds owned 5%. So the freely-traded shares were just 31% of the total shares outstanding. Porsche quietly acquired call options on the remaining shares. And, at the time, around 13% of Volkswagen shares were sold short. This, too, set off a massive scramble; it would have been one of the biggest financial stories of the month, or the year, if it hadn't happened in September 2008. Porsche ended up reversing its decision and selling some shares, and Volkswagen’s price reverted to where it had been before the run-up.
Literal short squeezes are semi-common, though the extreme version where more than 100% of the shares are spoken for by owners who won't lend them out is quite rare. But there are plentiful examples of real-world short squeezes: of situations where someone has committed to providing more of something than they can afford to buy. Examples abound:
Employers in the US auto industry in the 1950s through 1970s had a massive short position in labor: they'd bought factories, which were depreciating by the day, and any labor disruption would cost them market share that would be hard to recover. So they faced a short squeeze that led to higher wages and stricter work rules.
The world has periodically gone through oil short squeezes, for much the same reason: if oil prices go up 5%, it's extremely hard to respond by consuming 5% less oil.
One way to look at leverage is that it's a short position in cash, which means that a financial crisis is just a short squeeze. (This is one reason that crypto used to be uncorrelated to the market, and has become correlated: people added it to levered portfolios as an uncorrelated asset, and that meant it went up and down based on what was happening in the rest of their portfolios.)
An airline that rebooks a passenger after a delay is a business with a short position in an empty seat traveling between two points. Sometimes, this is cheap to cover. Sometimes it's not.
Drop shippers also do this, especially when they list at a high price on a well-trafficked site and try to buy the same product at a lower price elsewhere once they get an order.
Financial systems work in part by making promises that have a high but not 100% probability of being fulfilled. And selling something in the hope of buying it back later at a lower price later usually fits that model. In other words, shorting is broadly healthy for the market, but it can cause trouble, especially when it creates an incentive to exaggerate the bear thesis or to trigger a death spiral. And one of the market's defenses against short selling abuses is itself a market mechanism: short sellers can get into a sort of trouble that other market participants can't even dream of.
Read More in The Diff
The Diff spends a lot of time talking about short selling, especially relative to its prevalence in the market. Which makes sense: there's a large body of research indicating that the cost to short a stock is actually predictive of future returns, i.e. that short sellers are better-informed than the average trader. Some examples:
It's Hard to Make Money Shorting Worthless Stocks ($): if the management's core competency is making the stock go up when it ought to go down, you should expect the median short position to lose money, at least at first.
The Pandemic's Second Derivative: Did Zoom Change the Elasticity of Oil? ($): while the world has a short position in oil, it's easier to exit than it used to be.
This piece on Adobe's Figma deal ($) casts it as covering a short position in lightweight alternatives to the Adobe suite.
And this piece on Gamestop ($) looks at the "easy money" theory of bubbles: it's not about how much money is floating around, but where it's easiest for that money to go.
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1. There is a more sophisticated response, too; depending on the thesis, short sellers will often sell more stock as the stock declines, through some combination of betting on momentum, wanting to keep a constant proportion of the portfolio, and believing that the market persistently underreacts to further evidence that the short thesis is correct. If you short $10,000 worth of something, it drops by half, you short more to keep your position at $10k, and this process repeats two more times, your profits total $15k on a position that was always $10k, i.e. short sellers can make more than 100% of their money on a thesis, just not on an individual trade.
2. They were, however, frowned upon; when Allan Ryan cornered the market in Stutz Motor Car shares, the NYSE booted him from the exchange. History is cyclical, and it would not be the last time a car company's biggest investor would get in trouble for trying to punish short sellers.
3. In this case, by bidding on behalf of clients without their knowledge in order to get around the treasury rules that limited individual bidders' share of total auctions. It wasn't an attempt to corner the entire treasury market, of course, just a way to set things up so that someone who automatically buys one-month bonds would have to buy them from Salomon and would have to pay a bit extra. This turned out to be a bad risk/reward.
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