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 caught in the dreaded short squeeze.
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What Is Short Selling?
Did you know 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 a company’s value will fall. Perhaps whispers about poor earnings 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 borrow them from your broker. I liken it to renting something; you get to use it temporarily but need to return it eventually. So keep that n mind about a VW short squeeze.
For example, you “borrow” or sell short 100 shares of GameStop for $400. You predict the price will fall because it’s so overvalued. Sure enough, the share price tanks, and 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.
Short Interest Ratio Defined
Like most things, 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 that we have a few 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. Then last but not least, we have the NYSE short interest ratio. Are you confused yet?
But we know 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 cautiously approached.
Defining Characteristics of a High Short Interest Stock
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 and GameStop short squeeze. If this trend continues, then you’ll know what to look for.
Many shares sold short and fewer shares were available to trade. With this in mind, if a sudden buying frenzy occurs, we see short-sellers frantically covering their positions to minimize loss.
- A significant pessimistic view is a short interest as a percentage of float above 10%
- Short interest as a percentage of float above 20% is exceptionally high
The Dreaded Short Squeeze
A short squeeze happens when a stock’s price rises, forcing traders who had bet its price would fall to buy it back to prevent even greater losses hastily. By repurchasing their short positions, a feedback loop got triggered. The increasing demand attracts more buyers, which pushes the stock higher. 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 history’s most prolific short squeezes. TSLA or Telsa shorts lost $245 billion in 2020 as the price soared 743%.
We have a fantastic video explaining how to trade a short squeeze. Check it out.
Let’s Talk About the VW Short Squeeze
Smack dab in the middle of the 2008 recession. One company bucked the trend. If the Volkswagen story tells us anything, 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 quadruple in two days. With that monster move, VW briefly became the biggest company in the world. Yes, the world!
VW Short Squeeze Timeline
Rewind to 2006 when Porsche announced they wanted to increase their position in VW. To do so, they invested heavily, purchasing VW’s shares by 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 it, betting 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, 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% became 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.
VWAGY Stock Rover Report 5/23.
The Fallout of the VW Short Squeeze
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 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 through October 2008, with VW stock price now hovering just above €900 and exceeding €1,000 in intraday trading.
As a result, Hedge funds shorting VW lost close to $30 billion, while Porsche made billions. Ironically, this was when industry car sales were doing exceptionally badly.
How Long Did the 2008 VW Short Squeeze Last?
As you know, with short squeezes, they don’t last. So what happened next was no shocker. Within four days, shares fell 58%, and within a month, the price was down 70% from its peak on October 28th. Ally Invest chief investment strategist Lindsey Bell said it was a classic short squeeze pattern.
We see a rapid price rise followed by a swift fall from grace with any short squeeze. And, when the squeeze, everyone tries to sell simultaneously.
But typically, all squeezes end the same way, with the stock returning to where it started its flight. Most 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.
5 Minute Takeaway
- In 2008, Porsche bought up so much of Volkswagen’s stock it caused VW’s stock prices to soar.
- Within two days, price of VW quadrupled. In turn, this caused short sellers to lose tens of billions of dollars in a span of a couple of days.
- Hedge funds lost $30 billion in the VW squeeze
- Within four days, the stock dropped in price by 58%
- A similar phenomena happened with GameStop where hedge fund shorts got caught in a squeeze. Overall it cost them billions.
- A stock that’s actively shorted with a high short float and days to cover ratio is ripe for experiencing a short squeeze.
A Striking Similarity to GameStop
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.
Bottom Line
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.
