Contents
- Short Selling – What Is It?
- What Is Short Interest Ratio?
- Characterizing A Stock With A High Proportion Of Short Interest
- The Short Squeeze
- VW Short Squeeze
- VW Short Squeeze Timeline
- The Effects Of Volkswagen Short Squeeze
- How Long Did This Shot Squeeze Last?
- Similarity To Gamestop
- VW Short Squeeze Bottom Line
Have you heard about the 2008 Volkswagen short squeeze scandal?
It lasted four days and at the end of it, the company was worth 58 percent less than its peak value.
After that, it took hedge funds many weeks to regain their footing.
But what caused this to happen? And what even is a short squeeze?
We will cover all of this and more in this article, so keep reading to find out.
Short Selling – What Is It?
Did you know that it’s possible to generate money even while a stock’s price is falling?
This is achievable through short selling.
Suppose you have reason to assume that the value of a specific company will drop in the near future.
There may be rumors circulating about low profitability or bankruptcy, or any other rumors that the company may be in danger.
Shorting a stock may be justifiable for these reasons and many more.
When you short a stock, you borrow the shares from your broker and then sell them on the open market.
It’s similar to renting anything; you have access for a certain period of time, but you must return it at some point.
As an example, suppose you “borrow” or “short” 100 GameStop shares for a total of $400.
You feel that the price will be reduced because it is now overvalued.
As expected, the price of the shares plummets, and you seize the chance to repurchase them at the rock-bottom $40 price.
At this time, you return the rental shares to your broker and collect the $36,000 in profits owed to you.
What Is Short Interest Ratio?
There are no set rules to follow when calculating the precise math underlying the short-interest ratio.
Given that there are several methods for determining the value in question, it should not be surprising that traders regularly disagree on its definition.
The fact that there are several unique interpretations of the short-interest ratio further contributes to the situation’s complexity.
As a starting point, it might be the number of days to cover or the short interest stated as a percentage of float.
There is also the potential that it might be both.
However, we are aware of the fact that a short interest as a percentage of float that exceeds twenty percent is considered an unusually high level.
Moreover, if “days to cover” is larger than 10, this indicates an extremely negative outlook.
Due to these concerns, investing in a business with a substantial short interest should be approached with extreme caution.
Characterizing A Stock With A High Proportion Of Short Interest
Regardless of what definition you adopt, the basic concepts remain the same.
Similarly, each stock or index with a high short interest ratio possesses two distinguishing characteristics.
Both the Volkswagen short squeeze and the GameStop short squeeze comply with these guidelines.
If this pattern continues along its current track, you will know what to watch out for.
Numerous shares have been sold short, and/or there are limited shares available for trading on the market.
With this in mind, we watch short-sellers hurriedly covering their positions to limit the amount of loss they will incur in the case of a sudden buying frenzy.
- Short interest as a percentage of float that exceeds 10% indicates a severe unfavorable sentiment.
- Short interest as a percentage of float that exceeds 20% is said to be at a very high level.
The Short Squeeze
A short squeeze occurs when the price of a stock begins to rise, forcing traders who had bet that the stock’s price would fall to buy it back quickly to risk incurring even greater losses.
A feedback loop is formed as a result of their repurchase of short bets.
The increasing demand attracts other buyers, who in turn raise the stock’s price.
As a result, a rising number of short-sellers are compelled to repurchase their shares or cover their wagers.
One of the most effective short squeezes in the annals of financial history occurred not too long ago.
In 2020, short sellers of TSLA or Tesla stock lost a total of $245 billion owing to the 743 percent price rise.
VW Short Squeeze
One company defied predictions and flourished in the middle of the 2008 economic collapse.
If there is one lesson to be learned from the Volkswagen affair, it is that market manipulation may come from any side.
Not only affluent individuals and established institutions contribute.
On October 28, 2008, the share price of Volkswagen (VW) increased by more than triple in just two days.
As a result of this game-changing move, Volkswagen briefly became the most valuable company in the world.
VW Short Squeeze Timeline
In 2006 Porsche made the surprising announcement that it sought to strengthen its position inside VW.
To do this, they made significant investments, purchasing VW’s shares in bulk.
As predicted, the price of the stock continued to gradually rise over the years.
In this circumstance, you short the stock to the extreme, which is precisely what hedge funds did.
Hedge funds were monitoring the situation and, based on their view that the firm was considerably overpriced, they began shorting its shares in anticipation of a price decline.
The number of short positions had surged by the end of 2008.
Porsche’s ownership of 43 percent of VW shares, 32 percent of VW options, and the government’s ownership of 20.23 percent of VW proved decisive.
As a result, there was an incredibly restricted quantity of products available for sale to other buyers.
It meant that the real available float plummeted from 45% of outstanding shares to less than 1% of outstanding shares.
In other words, it signified that the float fell dramatically.
In addition, the “low” short interest rate of 12.8% resulted in a considerable supply and demand mismatch despite the fact that it appeared to be insignificant.
Therefore, it was vital that millions of shares be purchased immediately, despite the fact that there were no shares available for purchase.
The Effects Of Volkswagen Short Squeeze
According to a statement published by Porsche, the business “decided to make this announcement after it became apparent that there are far more short positions than anticipated.”
Not unexpectedly, the announcement prompted a panicked stampede of short VW stockholders to flee.
In addition, Porsche made their announcement on a Sunday, when the market was closed.
That is not unexpected.
Before the market was reopened, short-sellers would be unable to settle their wagers, leaving them in a vulnerable position.
This mismatch spurred short sellers to purchase additional shares in October 2008 to cover their bets, which pushed the stock price further higher.
The price of VW shares was now sitting slightly around €900, and at one point during trading, it reached an intraday high of €1,000.
As a direct result, hedge funds that had been shorting VW incurred close to $30 billion in losses, while Porsche made billions in gains.
Ironically, this occurred during a time when sales in the automobile sector as a whole were exceedingly sluggish.
How Long Did This Shot Squeeze Last?
Short squeezes don’t last long, but they can have devastating effects.
The subsequent events did not come as a surprise.
The price of the stock plunged by 58 percent in only four days, and by the 28th of November, it had fallen by 70 percent from its all-time high.
Whenever there is a short squeeze, we notice a sudden increase in price followed by an equally sudden decrease in popularity.
And when there is a scarcity, everyone attempts to sell their products simultaneously.
However, the end of a squeeze is nearly always the same, and the stock price often returns to where it was trading before the squeeze.
As a result, the majority of hedge funds maintained their positions during the volatility.
Because of this, they were handsomely rewarded when the stock fell 70% in a single month.
Similarity To Gamestop
The firm GameStop, which sells video games, will remember the 28th of January, 2021 for a long time.
In 2020, prices were largely constant at about $10.
Let’s fast forward to the year 2021 when prices increased 400% in a single day to reach $483.
You may attribute this to the WallStreetBets Reddit community.
Retail traders collaborated to start an assault on institutional investors by driving stock prices upward despite the stock’s large short interest.
In fact, GameStop followed Volkswagen’s example by drastically dropping their pricing to the $40 range, which had never been done before.
Everything occurred inside a single week.
VW Short Squeeze Bottom Line
We watched some of the most extraordinary brief burns ever performed.
Short selling has a terrific potential to create enormous profits, but it is not for business novices or the cowardly.
This is owing to the fact that there are several potential pitfalls associated with short sales.
Ensure that you do all of the necessary research before beginning to get into short selling.
Due to the complexity of this type of trading, you certainly do not want to find yourself on the losing end of a transaction.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
