GameStop, Short Squeezes and Fad Stocks

What a wild week on Wall Street. And it was driven by Main Street.

We’ve gotten used to the rise of the “fad stocks” that move higher because of their Internet fame (hello, Tesla). But this week, the internet latched onto down-and-out stocks in hopes of teaching short sellers — Wall Street’s most vocal investors — a lesson through short squeezes. And it was madness.

GameStop, an unprofitable video game retailer, became social media’s biggest target. In a matter of two weeks, GameStop’s shares soared from under $20 to almost $350 (as of January 27 close). We’ve seen some wild things in the market lately, but this might just take the cake.

Short squeezes aren’t a new phenomenon. And as many seasoned investors know, they aren’t exactly easy money.

Here’s what you need to know, including how to think through investments in fad stocks and short squeezes.

What’s a short squeeze?

Short selling involves borrowing shares of stock with a goal of selling those borrowed shares and then, (hopefully) buying the shares back at a lower price. The short seller then returns the borrowed shares to their original owner, having pocketed the difference between selling high and buying low.

Short sellers play an important role in markets, and they often serve as the watchdogs for fraud and deceit in stocks. Shorting doesn’t always work out though. Sometimes, the price of a shorted stock rises quickly, and the short seller (person betting the stock is going lower) is forced to buy back the stock at a higher price before their losses pile up. That’s a “short squeeze,” and it can lead to a surge in buying if the stock is heavily shorted. Remember, the short seller’s gain/loss is calculated as the price they sold the shares for at the start of the transaction, less the price they bought it at.

Short sellers and short squeezes have been around for generations. In 1863, Cornelius Vanderbilt organized a short squeeze against investors who shorted Harlem Railway. In the early 1920s, the founder of Piggly Wiggly (a grocery store chain) infamously ignited a short squeeze in his own stock, which eventually ruined him financially. Another legendary short squeeze took place in 2008, when a short squeeze in Volkswagen shares made the carmaker the biggest publicly traded company in the world.

Following the Crowd

This week, short sellers found themselves on the wrong side of the market. Dramatic short squeezes organized by social media fueled crazy, inexplicable moves in individual stocks.

A Week of Dramatic Short Squeezes

Performance in the Top 10 Most-Shorted Russell 3000 Stocks

Source: Ally Invest, Russell Indexes, NYSE
*Short interest data as of 1/15/2021

The top 10 most-shorted stocks in the Russell 3000 have risen an average of 36% this week, compared to a 1.7% loss in the index. Bed Bath & Beyond, a struggling home goods retailer, jumped as much as 75%. AMC, a movie theater chain on the brink of bankruptcy, has increased as much as 500%. The stock price of a holding company for Blockbuster (yes, the Blockbuster that went bankrupt years ago) has exploded.

Options tied to these stocks have become a feeding frenzy too. An average of 1.3 million GameStop options have traded each day this week, compared to its 48,000 average daily options volume in 2020. Option prices have blown through the roof and big options dealers, called market makers, juiced the squeeze by hedging their risk through the purchase of stock.

The Danger of Short Squeezes

Short squeezes seem exciting on the surface: They lead to higher prices and epic market stories. But they can be a dangerous proposition for both sides.

This particular short squeeze could follow the classic pattern of past squeezes: quick rise, quick fall. In the Volkswagen squeeze, shares soared 300% in just two days, then plummeted 44% on day 3. So far, we’ve already seen massive swings up and down in GameStop. On Monday and Wednesday, GameStop shares slid more than 50% intraday (before rocketing higher again). The stock was even halted a few times for volatility. Squeezed stocks can move violently for no reason, and the tide can turn quickly. And when the squeeze is done, everybody tries to sell at the same time.

Staying Sane

So how do you stay sane in this madness?

The lure of the short squeezes. Chasing the squeeze is like buying a lottery ticket. You might profit, but you might also lose everything. This type of speculative trading is more about luck and less about skill. If you benefitted from a pop in any of the short squeezes and locked in those gains, consider yourself one of the lucky ones.

Understand the risk in options. When you trade options on a wild stock, your trade doesn’t just depend on the stock’s direction. Options prices can swing wildly (like they have in GameStop), especially if the stock is heavily shorted and shares are hard to borrow. And some options trades, like call selling without a hedge, have unlimited loss potential.

Do your homework on fad stocks. It’s tough to sort through what’s legitimate and what’s not, and many fad stocks’ stories can end poorly. Just look at Nikola, the electric vehicle stock whose shares surged eight-fold last year before they tanked on allegations of fraud (even duping GM). Or Hertz, whose stock spiked 900% in May after it started bankruptcy proceedings (spoiler alert: Hertz tried to sell more shares, the SEC stepped in, and it’s still bankrupt).

The key is to look for fundamental reasons (earnings, cash flow, new strategy, or management) that back up the move higher in a stock. If that is missing, you may want to rethink your investment strategy on a particular stock.

Fads and short squeezes aren’t going away. It’s human nature to follow the crowd, especially when it looks like the crowd is right. When you’re stuck at home with nothing to do, stock speculation may be extra enticing.

Gains are rarely this easy though.

Callie Cox, Senior Investment Strategist, contributed to this article.

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.

Options involve risk and are not suitable for all investors. Review the Characteristics and Risks of Standardized Options brochure (https://www.ally.com/resources/pdf/in…) before you begin trading options. Options investors may lose more than the entire amount invested in a relatively short period of time.