Have you heard of the VW short squeeze of 2008? It lasted four days and fell 58% from its high. Hedge funds took weeks to recover from that. For those of you following the hype of GameStop the last number of weeks, it might have felt erringly familiar. That’s because it has happened before. If you were around for the 2008 VW short squeeze, you know what I’m talking about. But first, we need to talk about short selling, so you don’t get yourself caught in the dreaded short squeeze.
Did you know that you can make money when a stock is falling in price? Yeah, it’s possible through short selling. Let’s say, for some reason you believe the value of a company is going to fall. Perhaps whispers about poor earning or bankrupts are whirling, or maybe it’s an airline company that can’t fly due to a pandemic. All of these reasons could be justification for going “short” on a stock.
When you short a stock, you don’t own the shares outright, but you borrow them from your broker. I liken it to renting something; you get to use it temporarily, but you need to return it eventually. Keep that n mind about a VW short squeeze.
As an example, you “borrow” or sell short 100 shares of GameStop $400. You predict the price will fall because it’s so overvalued. Sure enough, the share price tanks, you repurchase them back at the bargain-basement price of $40. At this point, you return your rented shares to your broker and bank $36,000 in profits.
Like most things in life, there aren’t black and white criteria for calculating the exact math behind the short-interest ratio. And it’s no surprise that traders often disagree on the definition because there’s more than one way to calculate it.
Further complicating matters is the fact that we have a few different definitions of short interest ratio. To begin with, it could be the number of days to cover or the short interest as a percentage of float. Last but not least, we have the NYSE short interest ratio. Are you confused yet?
But what we do know is that a short interest as a percentage of float above 20% is considered extremely high. Furthermore, “days to cover” above 10 indicates extreme pessimism. For these reasons, a high short-interest stock should be approached with extreme caution.
Despite which definition you use, the fundamental principles are the same. For that matter, any stock or index with a high short interest ratio has two defining characteristics.
You’ll see these principles in both the VW short squeeze and the GameStop short squeeze. If this trend continues, then you’ll know what to look for.
A high number of shares sold short and/or a low number of shares available to trade. With this in mind, if a sudden buying frenzy were to occur, we see short-sellers frantically covering their positions to minimize their loss.
A short squeeze happens when a stock’s price begins to rise, forcing traders who had bet its price would fall to hastily buy it back to prevent even greater losses. By repurchasing their short positions, a feedback loop got triggered. The increasing demand attracts more buyers, which pushes the stock higher. In turn, this causes even more short-sellers to buy back or cover their positions.
We don’t have to look too far back for one of the most prolific short squeezes in history. TSLA or Telsa shorts lost a combined $245 billion in 2020 as the price soared 743%.
We have a fantastic video on your website where we explain how to trade a short squeeze, check it out.
Smack dab in the middle of the 2008 recession, one company bucked the trend. If the Volkswagen story tells us anything, it’s that market manipulation can come from both sides of the table. It’s not just from big money and institutions.
For a brief moment, on October 28th, 2008, Frankfurt-based company Volkswagon (VW) saw its shares more than quadrupled in two days. With that monster move, VW briefly became the biggest company in the world. Yes, the world!
Rewind to 2006 when Porsche made a surprise announcement that they wanted to increase their position in VW. To do so, they invested and invested heavily, purchasing VW’s shares by the boatload. Predictably, the stock price started to rise steadily over the years.
What does one do in this scenario? You short the heck out of it, and that’s exactly what the hedge funds did. Hedge funds were watching and felt the stock was majorly overvalued and began shorting the stock, betting that it would go down eventually.
By late 2008, short positions ballooned. The kicker was that Porsche owned 43% of VW shares, 32% in options, and the government owned 20.2%. As you can see, this left very little that could be purchased by anybody else.
In plain terms, it meant that the actual available float went down from 45% of outstanding shares to around just 1% of outstanding shares. Furthermore, the seemingly “low” short interest of 12.8% turned into a massive supply and demand imbalance. Thus, millions of shares needed to be bought immediately even though there were simply no shares available to be sold.
Porsche stated that they had “decided to make this announcement after it became clear that there are by far more short positions in the market than expected.”
Despite the disarming choice of wording, Porsche’s statement had precisely the effect we expected. Sure enough, the announcement triggered a mass panic for the exits by anyone who was short shares of VW. Porsche had also made this announcement on a Sunday when the market was closed. No surprise there. Because of this, short-sellers would have zero ability to cover their positions until the market reopened.
This disparity caused short sellers to rush to buy more stock to cover their positions, driving the stock price further still through October 2008, with VW stock price now hovering just above €900, and at one point exceeding €1,000 in intraday trading.
As a result, Hedge funds that had been shorting VW lost close to $30 billion, while Porsche made billions. Ironically, this was during a time when industry car sales were doing exceptionally badly.
As you know, with short squeezes, they don’t last. What happened next was no shocker. Within four days, shares fell 58%, and within a month price was down 70% from it’s peak on October 28th. According to Ally Invest chief investment strategist Lindsey Bell, it was a classic short squeeze pattern.
We see a rapid rise in price followed by a swift fall from grace with any short squeeze. And, when the squeeze, everyone tries to sell at the same time.
But typically, all squeezes end the same way with many times the stock just going back to where it started its flight at. The majority of hedge funds knew that and held their positions through the turmoil. Because of this, they were rewarded handsomely when the stock dipped 70% in one month.
January 28th, 2021 was a date that will go down in the books for video game retailer GameStop. 2020 saw prices hovering around the $10 range. Fast forward to 2021, and prices soared in one day by 400% to $483. You can thank Reddit’s WallStreetBets forum for that.
Retail traders coordinated an attack on big money by driving stock prices up despite the stock’s high short interest. Sure enough, GameStop followed Volkswagen’s path with a rapid fall in price to the $40 range. All within a week.
We saw some of the most tremendous short burns of the century. Short selling is a great way to make significant profits, but it’s not for the inexperienced or faint of heart. That’s because there’s a whole lot that can go wrong when it comes to a short sale.
The most important thing that you can do is make sure that you’ve done your homework. This type of trading is a very complicated game, and you don’t want to find yourself on the wrong side of a trade. Let us help you in your trading journey. We have thousands of dollars of free courses and videos to get you started.