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Home >Markets >Mark To Market >A brief history of short squeezes before GameStop

MUMBAI: Given the current trend of reversion to the meme, the task of explaining a short squeeze is best left to redditors. An r/wallstreetbets user, Scheebs_, whose account now stands suspended, had put this explainer for dummies a few days ago. “⁠Let's say 5 bananas currently cost $10. ⁠One ape on the market has 5 bananas; a snake asks to borrow 5 bananas for a bit and instead sells the 5 bananas thinking the price will go down soon (shorting or short selling). He thinks he can buy them later for less and give them back to the ape, and make a profit on the difference. The ⁠group of apes notice what the stupid snakes are doing and decide to buy all the bananas on the market, until snakes have no other choice than to buy from the group of apes in order to return what they borrowed (short squeeze)." Evidently, the apes represent the redditors looking to corner shares of firms shorted by hedge funds, who are referred to as snakes in the above story.

The word ‘squeeze’ refers to the difficulty the snakes (read short sellers) will face, if they can’t find enough bananas (read shares) to buy in the market and square off their short positions. The higher the amount of bananas their opponents are able to corner, the tighter the squeeze, and hence higher the losses at which they will be able to buy the bananas back.

Redditors, in one sense, are dreaming of the day hedge funds will grovel at their feet and pay the price they name for stocks such as GameStop Corp. One such hedge fund-- Citron Capital--shorted the stock at $40 a piece and hoped to buy it back at $20, hoping to make a gain of about 100%, before accounting for transaction and stock borrowing costs. It eventually exited at a loss of about 100%, implying it bought back the shares at around $80. Melvin Capital booked far greater losses, requiring a $2.75 billion bailout from friends.

The apes, meanwhile, are rallying the troops to hold on to their positions, so that others with short positions are squeezed and made to pay through their nose as well. Note that the snakes went into the trade with return expectations of about 100%; some of the apes were at one point sitting on paper profits of over 10,000%, but were still holding on to their positions.

But there has been a long history of market corners and short squeezes, years before the current battle between apes and snakes.

Piggly Wiggly

About a hundred years ago, in the US stock markets, a businessman by the name Clarence Saunders took a trip to New York with $10 million of borrowed funds to fight a bear cartel. His retail business chain, Piggly Wiggly, was doing fine except for some failures at some franchisees. The bear cartel sought to take advantage of the recent failures and started shorting the stock, besides spreading rumours about the firm. The story is captured in the chapter, The Last Great Corner in the book Business Adventures by John Brooks.

“Saunders began a buying campaign in New York, with an attempt to corner the floating stock of Piggly Wiggly shares. “The stock went up wildly, reaching a high of $124," writes Brooks.

But just when it seemed that Sanders had single-handedly trumped Wall Street, “the Exchange suspended further trading & postponed the short sellers' delivery deadline." The short sellers managed to find shares for delivery, thanks to the extended deadlines. “This resulted in eventual bankruptcy for Saunders and he was finally forced to step out of the Piggly Wiggly Company," says Brooks.

Saunders got a lot of sympathy at the time, since the sudden change in exchange rules seemed unfair; not unlike some of the sympathy for the redditors whose short squeeze plans were hit after their trading options were squeezed by service providers such as Robinhood.

VolksWagen

In the history of short squeezes, perhaps the most famous one is that of German automaker, VolksWagen, also known as VW. This will please the apes, because certain hedge funds took massive losses after shorting VW ordinary shares, after the firm became the most valued firm in the world in a brief wild period of trading.

The squeeze played out right in the middle of the global financial crisis, but began as early as 1931, as mentioned in this summary by Jamie Powell of Financial Times.

VolksWagen was in the process of being acquired by Porsche, and the premium of its ordinary shares had risen to extremely high levels compared to its preference shares. The hedge funds smelt an arbitrage opportunity. Sell the ordinaries and hedge by buying the preference shares. What gave them confidence was that there was no news of Porsche continuing its purchase of VW ordinaries from the market; but they were blindsided because it was buying cash-settled options instead. One weekend, Porsche announced its total holding in VW. It had cornered the majority of the float, leaving only 6% in free float. Short sales, meanwhile, had risen to 12% of total outstanding stock.

“It was mathematically impossible for every short-seller to buy a share, and therefore close their position. In other words, half the room were going to be left in a burning building with no way out. A panicked dash for the exit began," wrote Powell. On the Monday that followed, some short sellers managed to “squeeze out of the fire escape", but far worse was to follow who waited till Tuesday, when VW shares skyrocketed to record levels of €999 a piece. Hedge funds are estimated to have lost some $30 billion by betting against VW ordinaries.

In an irony of sorts, even though Porsche managed to burn many short sellers, it couldn’t pay up for the large positions it had created, and ended up being acquired by VW instead.

Herbalife

Bill Ackman, a hedge fund manager, took a $1billion short position in Herbalife, a global multi-level marketing firm. Ackman’s case was that the company was a fraud pyramid scheme, and he eventually won a pyrrhic victory when the Federal Trade Commission took enforcement action against the firm in 2016.

But as for Herbalife shares, they doubled since Ackman’s bet, thanks to huge long bets taken by other billionaire investors such as Carl Icahn, who became the firm’s largest shareholder. In a long-drawn battle of egos, which included a live spat on CNBC, Icahn eventually prevailed, with huge gains, while Ackman’s fund reportedly took a loss of $1 billion.

Tesla

Tesla and its founder Elon Musk have squared off with short sellers regularly, and despite run-ins with the Securities and Exchange Commission (SEC), for now, the former has been winning the battles. Short bets on Tesla were sitting on mark-to-market losses of over $40 billion at end-2020, as the firm’s shares surged 740% last year. This is based on data collated by Ihor Dusaniwsky, managing director of predictive analytics at S3 Partners, a financial-analysis company.

It’s little wonder Musk and the redditors have found much in common and the former continues to rally the ape troops through his tweets. Dusaniwsky told Institutional Investor that shorting Tesla is “by far the longest unprofitable short I’ve ever seen."

While companies and founders have a dislike for short sellers, because they can bring down stock prices and cause the cost of capital to rise, Musk’s disdain for the short selling community is unrivaled; with perhaps only the r/wallstreetbets community giving serious competition. In mid-2020, Musk took a dig at short sellers by releasing “short shorts". These now sell at a premium on ebay.

Despite Musk’s wins, the shorts haven’t budged much, Tesla continues to be the most shorted stock in terms of the value of short positions. The rally in Tesla shares, experts say, is not so much because shorts are covering, but because of large amounts of buying in out-of-the-money options, where premiums are low. With such trades, option writers hedge their position by buying a certain quantity of the underlying stock, pushing up prices partly as a result. Then, there was the the whole Robinhood phenomenon which drove up some popular stocks such as Tesla. All of this led a so-called gamma squeeze, requiring option writers to buy a greater quantity of the underlying stock to hedge the position adequately.

The apes, too, have built up large positions in GameStop using call options, and the gamma squeeze strategy appears to have worked to an extent as well. Of course, with the same logic, corrections can be equally sharp and severe when the price trend reverses, and option writers cut positions, alongside others looking to exit.

Reliance (RIL)

Not unlike Piggly Wiggly’s Saunders, Dhirubhai Ambani was incensed when he realized a bear cartel was trying to profit by shorting Reliance shares, and that too just ahead of a large convertible debentures issue by the company. And like Saunders, he too, decided to single-handedly fight the bear cartel. But unlike Saunders, the bears were squeezed and Ambani won, giving him a legendary name in Dalal Street.

At the time, the Bombay Stock Exchange followed a 14-day settlement cycle. In other words, settlement of buy and sell transactions happened only once every fortnight. While the bear cartel had initial success in driving shares of Reliance down, a group called "Friends of Reliance Association" was quick to purchase the shares that were being sold and supported the stock. Eventually, when it was time to make good the delivery of the shares, it turned out that the bears had nowhere else to go but Reliance or its friends. Chander Uday Singh, a journalist for India Today in the 1980s, wrote, “panic-stricken bears promptly began bidding for any Reliance shares that were available in an attempt at fulfilling their sale commitments. In the bedlam that followed, the stock exchange had to be shut down for three days while the exchange authorities tried to bring about a compromise between the unyielding bull and the bears."

Eventually, the bears bore a loss of over 3 crore, according to reports, and Ambani and Reliance earned the following reputation, according to Singh: “Play with Reliance shares, and you play with fire".

Singh’s report highlights that the battle led to losses for investors trading even in other shares.

To close, while the GameStop short squeeze is portrayed as just desserts for the snakes who tried to mess with the apes, the fact also remains that many so-called apes will buy stocks near the top and will bear high losses when the dust settles. And while some hedge funds may have been burnt their fingers, others will gain from the chaos on the Street.

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