The Art of the Short Squeeze & Corner

As markets get extended, it is not surprising to see extreme volatility and some stupidity, often resulting in massive losses. This year already, we have witnessed two epic short squeezes, both resulting in huge losses for the perpetrators. I refer of course to Tesla and GameStop. The cases are different because the GameStop short squeeze was accompanied by a well-designed and executed cornering of the market, whereas Tesla was simply a very bad market call.

Source: Factset

A short sale is a perfectly legal and ethical but somewhat risky maneuver. The investor, sensing a stock is going to fall, sells stock that they do not own, with the goal of buying it back later at a lower price. After enacting the sale, the investor is required to deliver the stock on settlement day or risk large penalties if they fail to meet this obligation. To make good on delivery, the seller will arrange to borrow stock from another shareholder and deliver that stock when the investor buys back the position later.

Investors that made a bet that Tesla’s share price would tumble from its already nosebleed inducing heights, badly misjudged the market as the stock surged higher by over 600% in six months.

In the case of GameStop, the surge in prices was caused by an intentional short squeeze. It is instructive to review another well-designed cornering of the market aimed at damaging those who shorted the stock.

This incident goes back one hundred years to a grocery store stock called Piggly Wiggly. The founder of Piggly Wiggly Stores Inc. and the inventor of the modern-day grocery store, Clarence Saunders, listed the stock on the Chicago Stock Exchange in 1919. Business was booming and Piggly Wiggly had sold plenty of franchises. Herein lay the problem; one of the larger franchisees went bankrupt and confused shareholders sold the stock of Piggly Wiggly, believing the listed firm to be in trouble. Enter the short sellers, sensing blood. They drove the stock down dramatically, much to the chagrin of Clarence who mounted a stellar defense by borrowing $10 million to buy back Piggly Wiggly stock. In addition, the company’s treasury was used to purchase stock as he issued new stock in Piggly Wiggly for settlement at a future date and, used those funds to buy stock in the current market. Armed with such a war chest, Clarence managed to buy enough stock to corner the market, leaving those holding short positions insufficient stock available to cover their positions. The “shorts” were skewered.

Clarence agreed to sell his stock back to them at $150 having driven the price up from $30. However, the art of cornering a market is to ensure that the short sellers caught in the squeeze, cannot borrow the stock. In this case, the SEC came to the sellers’ rescue by extending the settlement date on their trades long enough for them to find new stock lenders, driving the stock price down to more normal levels. Clarence, with a huge position that he had overpaid for, eventually went bankrupt.

In a similar fashion, the buyers of GameStock who had squeezed the shorts were waylaid by Robinhood, their broker, who for regulatory reasons had to cease trading in the stock, which then plummeted, leaving some new buyers with very expensive positions and large losses.

It should be noted that we do not fully believe the myth that GameStock short sellers were highjacked by the little guy (i.e., retail investors on Robinhood). They may have started the run, but to really get the squeeze going, they likely had some help from hedge funds who smelt the blood of the competition that was short the stock. The average size of the purchases as the squeeze got underway became too large for the average retail investor. But it is a nice “David & Goliath” story? As certainly one large hedge fund was taught the dangers of engaging in destroying an enterprise, by relentlessly shorting its stock.