Home Business Insights & Advice How short squeezes came to dominate the retail investing landscape

How short squeezes came to dominate the retail investing landscape

by John Saunders
22nd Sep 21 12:29 pm

2021 has been a significant year for the world of investing. Alongside an unprecedented rise in global IPOs, we’ve also seen significant short squeezes – with GameStop and AMC stocks front and centre of the year’s most impressive price rallies. With the recent rise of retail investing, short squeezes may become a dominant force across the stocks and shares landscape. 

As we saw in the GameStop short squeeze of January 2021, a new wave of retail investors have shown that they’re able to coordinate themselves via social platforms to confound short sellers and generate huge stock price rallies for themselves. 

With platforms like Robinhood making it easier than ever for casual investors to buy and sell shares, there’s no reason why short squeezes won’t continue into the future, but first, let’s take a deeper look at what a short squeeze actually is and why it’s become such a hot topic in the investment landscape.

What is a short squeeze?

Short squeezes happen when many investors short a stock, or make a bet that its price will fall, but instead the stock’s price shoots upwards instead. 

For example, let’s say an investor believes that shares of Company A are overpriced at their value of £100, then that investor can borrow someone else’s shares of Company A and sell them on at their quoted £100 price. 

However, you can’t sell something you don’t own, and at some point those shares would need to be eventually returned. When it’s time for the investor to return the shares they’ve sold, they will need to rebuy the shares and return them to the lender. If the Company A’s price has dropped as expected, to around £75, then the investor would’ve made £25 profit per share, and would be able to pocket the difference.

However, if Company A’s shares actually increase in price, then the investor who shorted the stock is in danger of losing money on their trade. If the stock rises sharply then short sellers may need to act quickly to close out their positions. When high volumes of short sellers are scrambling to exit their positions as Company A’s stocks are rising all at the same time, this can create a short squeeze. Essentially the sudden surge in demand will push the appreciating stock significantly higher. 

By extending this example, if Company A suddenly reported better-than-expected earnings and its stock price climbed to £120, then short sellers could rush to close out their positions before the price continues to climb off the back of the good news. This sudden high demand may push the price of the share as high as £150 – with the significant jump in price ‘squeezing’ the short sellers who believed the value would fall.

The rise of the short squeeze

Although short squeezes are nothing new, it’s somewhat unprecedented to see a coordinated group of retail investors to mobilise on Reddit at scale to pick their stocks to target en masse. 

At the heart of the GameStop was a Reddit group called r/WallStreetBets. The group noticed that hedge funds, including the likes of Melvin Capital, had taken out a large short position on GameStop, the US video game retailer. The group decided to target the Wall Street hegemony and rallied together to buy huge volumes of shares in the stock – forcing the price up significantly in the process and causing hedge funds to collectively lose out on billions of dollars. 

As the data above shows, these coordinated buying sprees have been capable of driving stocks up exponentially – with AMC’s peak in June 2021 marking a 3,000% increase over the start of the year. 

While there are no particular industries that these retail investors are targeting, we can see that the majority of the stocks that are pumping are more nostalgic rather than market leaders. Businesses like GameStop, AMC and BlackBerry – all of which have experienced squeezes to some extent – would all have played a more significant role in the formative years of today’s retail investors as opposed to now. 

These nostalgia and often meme-based short squeezes are easier to come by due to the increased likelihood of institutional investors taking up short positions over the industry stalwarts.

The increasing pool of retail investors

Another reason why short squeezes are becoming more dominant in 2021’s investing landscape is down to the larger volumes of retail investors entering the market. 

As data from India’s stock markets show, the gulf between individual retail investors and corporate and institutional investors has closed significantly over the past five years, with more of an even split evident today. 

Furthermore, we can see a sharp increase in the number of retail investors creating investment accounts online since the beginning of the Covid-19 pandemic in 2020, with 14.2 million new accounts opened in 2021 compared to just 1.8 million in 2016. 

Maxim Manturov, head of investment research at Freedom Finance Europe, believes that the accessibility of new financial products will help to further drive the volume of active retail investors in the market – “Millions of people now use mobile apps to trade stocks as easily as they do to share content on social media. In January 2021 alone, approximately 6 million US users downloaded the trading app, and retail brokerage firms reported record high daily average volumes, with this growth being observed globally. At the same time, approximately 10 million people in the United States opened a brokerage account in 2020, dubbed “the year of the retail investor” by some. In early 2021, retail investors in the United States generated roughly the same amount of equities trading volume as mutual funds and hedge funds combined.

To attract more retail investors, brokerage firms must improve their customer acquisition processes, lower the minimum investment threshold required to open an account, and make their platforms as simple, intuitive, and user-friendly as possible, as well as expand their funding options. Companies can also provide protocols for determining which investments are appropriate for new account holders in order to avoid costly mistakes at the outset. Some firms should consider implementing additional investor protection measures, such as enacting restrictions on leverage and derivatives and providing 24-hour support services. Firms should also consider additional staff training to educate clients about the risks of investing in high-volatility securities and adopting better methods of dealing with clients during market volatility.”

This huge influx of new investment has paved the way for more firepower as retail investors continue to combat the short positions of institutions. With a playing field continually levelling out, we may see more clashes between Reddit-based retail and Wall Street in the future.

 

The above information does not constitute any form of advice or recommendation by London Loves Business and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision.

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