Have you been wondering what happened with the GameStop/AMC situation from late 2020? Unless you were sequestered in a remote mountain cabin for the latter part of the year, you saw dozens of financial news headlines about the unique situation. So, in case you missed the key points of the story, one that is bound to change the entire way securities are bought and sold, here are the pieces, which can help you learn about a short squeeze and how to potentially use the technique to your advantage.
How it all started
GameStop (GMS) and AMC Theaters (AMC) are two companies that had something in common during the early months of 2020. They were both considered outdated, operating with a tired business model that relied on in-person customers in an increasingly cyber, e-commerce era. Investors weren't excited about the future of either stock's price, and there was a lot of talk in the media about how they were dinosaurs of the entertainment industry.
Reddit got involved
The social news and discussion website, Reddit, was hosting a sub-category for investors that focused on how bad the GMS situation was becoming. This social media activity is what was unique about the whole GameStop/AMC situation. For the first time in history, ordinary investors were able to communicate with each other instantaneously and have a direct impact on a company's stock price.
As some of the major Wall Street hedge funds and brokerage firms were short-selling the two stocks, based on the assumption that prices were about to fall sharply, participants on Reddit decided to buy the stock and see if they could reverse the fall. The strategy, completely legal and ethical in every way, worked. AMC and GMS share prices began to rise. The big hedge funds, who had sold millions of shares short the previous week, lost huge sums of money covering their short positions. Reddit's crew of amateur investors watched prices rise significantly, sold at or near the peak, and pocketed extraordinary profits.
None of the above makes any sense unless you have a firm grasp on two concepts: short-selling and squeezes. Shorting, a type of securities selling that gets a much worse rap than it deserves, has been around for more than 100 years, as has its conceptual cousin, the squeeze. The best way to figure it all out is with examples.
If you think the price of Company X stock is about to fall, for whatever reason, you certainly don't want to purchase it and hope for the best. Instead, you need only find someone who wants to purchase shares. When you do, you agree on a price with the buyer and do one of two things: you either promise delivery for the following day (or some agreed-upon date in the near future), and wait for the price to fall.
When it does, assuming you were correct, you then purchase however many shares you contracted to deliver to your buyer. But now, you don't have to spend much to acquire the stock because it costs so much less. Your buyer paid full price at the time of the deal. Your profit is the number of shares you sold, multiplied by the amount of the price drop.
The other way, which is actually more common, is for you to find a willing buyer who wants shares immediately. You don't have any in your inventory, so you borrow some from your broker/dealer, agreeing to repay them the next day, or whenever you mutually decide to settle up. Again, if your guess was right, and Company X stock dives, you simply repay your debt to the broker with the, now much cheaper, shares.
Here's where squeezing comes into play. The Reddit traders jumped into the fray when they say the value of GameStop and AMC dropping. They knew it was primarily due to hedge funds who were betting on a downward pricing spiral.
Thousands of Reddit readers bought GMS and AMC all at once, which not only stopped the downward spiral but caused dollar-values of the securities to rise. All those hedge fund folks who had shorted the two companies were terrified, and attempted to buy more stock to cover their short positions. That drove values up even higher.
Then, as quick as they bought in, the Reddit investors sold, and made a handsome profit. What they did was called a short squeeze, a technique in which prices of a given security are falling, but then reverse. If you can identify the dip and the peak, it's possible to make money from a squeeze.
Disclaimer: The information and views provided in this article are solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.