All this discussion around the impressive stock price moves we’ve seen in stocks such as Gamestop (NYSE:GME), AMC Entertainment (NYSE:AMC), and BlackBerry (TSX:BB)(NYSE:BB) has created a frenzy. Many retail investors (the little guys like you and me) have piled into trades that have gone parabolic. Some have made fortunes; others have lost tremendous amounts of money. In recent days, there has been more downside than upside. Indeed, many of these trades have imploded, leaving those who bought at the top holding the bag.

Retail investors on the Reddit forum “wallstreetbets” have targeted Wall Street, and in particular hedge funds focused on short selling, as a protest against stock price manipulation. There has been chatter for some time that this movement is an extension of the “Occupy Wall Street” protests in recent years. In short, the little guy is out to get the big guys.

For those wondering what happened, and are asking questions like “what is short-selling” or “what is a short-squeeze” I’m going to address those in this article. I’ll try to describe how these financial concepts work in layman’s terms.

Short Selling

The concept of selling a stock short is akin to betting against a stock. If you think a stock will drop, you can bet against said stock by selling a borrowed stock you don’t own.

The short seller receives the proceeds from the sale of the borrowed stock up front, and can use that money to buy better stocks, or just hold onto the money until he buys back the stock. The short-seller pays a borrow fee to the brokerage firm for the ability to sell a stock he doesn’t own, and the lender of the security (whoever owns the stock) receives a cut. It’s a win-win-win type of agreement.

At some point in the future, the short seller will have to buy back the stock he sold at the market price. If the market price is below what he sold the stock for, he will make money. If the stock rises, he loses money.

Herein lies the risk. Stock prices can, in theory, go to infinity. The losses short-sellers can incur are therefore unlimited. Unlike buying a stock, which can only theoretically go to zero (and thus one’s losses are limited to 100%), a short-seller can take a loss of 1,000% or 10,000% or higher, if the stock climbs in a parabolic fashion in a short amount of time.

Short Squeeze

The retail investors intent on bankrupting short-selling hedge funds are banking on the idea that if enough investors band together and hold enough of the free-trading float, short-sellers won’t be able to cover their trades (i.e. buy back the stock they sold). Additionally, if there’s not enough outstanding shares to allow short-sellers to cover, and those holding the underlying stock demand repayment, short-sellers will be forced to buy the stock back at whatever price it’s trading at. In other words, those holding a stock that is heavily shorted can “squeeze” short sellers and force them to cover their positions at massive losses.

Note that Gamestop has had a short ratio of over 100% for some time, meaning more than the entire float of shares trading at a given time was shorted. In this type of scenario, a squeeze is more likely to incur, if massive buying takes place.

Since the strong buying from retail investors buying up the float will drive prices higher due to the law of supply and demand, these higher prices should force a frenzy among short-sellers to cover their positions. As short-sellers start buying back the borrowed stock en masse, the underlying stock price rises even faster. This causes the type of price action we saw with Gamestop, AMC, BlackBerry and other companies these past couple weeks.

Those speculating on a short squeeze taking place added fuel to the fire, however it appears this trade may be coming to an end. Some believe that there’s still the possibility for a bigger short squeeze on the horizon.

What Will Happen From Here?

I’m unsure of what will take place in the coming days. What I am sure of is these types of scenarios are very rare, and present interesting case studies in what can happen when too many individuals pile into a trade at the same time. Investors looking to get in on the action, on either side of the trade, should only do so with what they can afford to lose. Over the long-term, engaging in trades like these are losing bets.

That said, the fact that we’ve seen a short squeeze materialize is fascinating from an educational standpoint. Many investors who have little knowledge about investing have gotten a tremendous lesson in the intricacies of how finance works in the past couple weeks, even if it was an expensive lesson.

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