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This episode aired on BloombergTV on Feb 15, 2013

Short Squeeze

Short squeezes are situations in which a a heavily shorted stock suddenly experiences a jump in price, as the result of a self-reinforcing cycle involving several related forces. If a shorted stock’s price starts to rise, short sellers will need to make margin calls, and some will cover their short sell by buying the stock. These actions can cause the stock’s price to rise mroe, triggering another round of margin calls and covers.

Q. So this is a potential problem for Bill Ackman in the Herbalife situation… obviously it involves people buying the stock to push the price up, while he’s shorting the stock to push it down, but how does it work exactly?

A. It’s much more complicated than just a tug of war between buyers and sellers. The big thing to recall here is how you execute a short sale in the first place: you borrow the stock you’re selling… (“naked” shorting–just selling shares that you haven’t borrowed– is illegal). Somebody has to loan it to you. And that complicates things mightily if the share price actually starts to rise and not fall.

Q. On one level it’s obvious why, because the short seller has an obligation to return the stock to the lender – and the cost to do that keeps going up.

A. Right, which will usually result in margin calls, so the short seller has to put more and more money up to prove he can make good on that obligation. But there are other things going on at the same time that contribute to the short squeeze.

Q. Because of the mechanics of how the stock gets borrowed?

A. Yes. As the stock starts to rise, some people who hold it naturally want to sell. When they do, the loaned stock is called back from the borrower and sold into the market. Now, to keep his short position, the short seller has to find somewhere else from which to borrow it.

Q. And as the stock goes up in price, that becomes more difficult, I guess?

A. Right. First of all, when you borrow the stock, you have to agree to pay the lender a rate of interest– it’s a loan, after all. And the lenders of the stock– who are the institutions holding the stock in brokerage accounts– are smart… they just start charging higher and higher rates to lend it. And often the buyers of the stock, the people on the other side of the short seller wont let their brokers lend it back out.

Q. So the supply of stock that can be borrowed dries up.

A. Right…. That’s a true short squeeze. The short seller is forced to buy shares in the open market to cover… which just pushes the price up, in a reinforcing cycle that can, very quickly, cause the price to do a moonshot.