Max Pacella
Investment Analyst
Equities
29 Apr, 2021

A short squeeze is a situation that occurs when an asset price trades sharply higher, due to a supply/demand imbalance.

In most cases, it’s when short sellers, those who are betting that the asset price will decline, have to quickly cover their positions as the price rises, rather than paying higher and higher margins (read: cash) to facilitate their short positions.

As of late, the  terms ‘short squeeze’, ‘call options’ and ‘gamma’ are ingrained into the minds of market observers after the GameStop saga, let’s take a short trip down memory lane back to yesteryear of 2008 – where can be found what was called the “Mother of all Squeezes”.

A “Hedge Fund That Makes Cars”

Back in Q3 2008, Volkswagen was considered by many in the market to be an ideal ‘short’ candidate.

The company had fallen on difficult financial times and increasingly leveraged itself to keep doors open, the market itself was in the middle of the worst financial crisis of the decade and the VW share price was elevated at levels seemingly in excess of what was ‘fair value’.

VW was not alone, many automakers were considered likely to go bankrupt as their balance sheets were barely supporting levels of debt which could not be serviced under sinking new car sales figures.

General Motors and Chrysler were about to be bailed out to the tune of $13.4 billion USD, only for GM to file for bankruptcy a few months later. Suffice to say, the backdrop was not exactly bullish.

But this is where the short squeeze begins – and much like the GameStop saga recently, the short coverage on the free stock was at excessive levels.

Porsche, a company in arguably a worse financial position than VW, had been slowly building an equity position in VW in the years preceding 2008 – all the time seeming to indicate to the market that it would not go for a takeover bid.

Then in October 2008, Porsche announced to the market that it had increased its stake to 74.1% of VW. You see the short coverage was not excessive to the uneducated observer, in fact it seemed to be a reasonable 13% of outstanding stock – but most of that ‘outstanding stock’ was locked up in government or index funds, both of which were not in a position to sell out easily. In fact, around 55% of VW shares were illiquid to the market, and Porsche had just purchased 42.6% more of a stake.

So, there was now a massive demand to buy stock, with only 1% true outstanding shares.

Porsche made this announcement on a Sunday, with a statement that “the disclosure should give so called short sellers… the opportunity to settle their relevant positions without rush and without facing major risks” – it seems they had a cruel sense of humour.

The next day the stock price tripled from just above 300 EUR to over 1,000 EUR, briefly making VW the most valuable company in the world.

Source: Bloomberg

The Lessons We Can Learn

Short squeezes are not as uncommon in the market as you would think – the group of hedge funds colloquially known as “The Tiger Cubs” used to ‘hunt shorts’ together to make quick profits habitually in the early 2000s.

Each time a large squeeze occurs, like VW or GameStop, the market reacts in some way to try and counteract this strategy; for VW there was greater attention paid to the purchase of cash-settled options, for GME market makers began adjusting option pricing to slow down these type of squeezes.

But they always return – shorting is risky business and it is often a few players against the vested interest of the rest of the market.

There are a few takeaways from the VW “Infinity Squeeze” which were applicable to GME, as they may be applicable to the future:

Source: Bloomberg
  1. Take interest when the price of a stock seems contrary to market sentiment; VW’s ordinary and preference shares diverged dramatically as Porsche began to aggressively buy options, a warning sign that something wasn’t right.
  2. The market is forecasting implied volatility;

    This is a historical signal that the market is expecting a large move – think of this as constrained momentum waiting to be released in one way or another. And when the market is moving, squeezing is seen more frequently and more aggressively.
  3. Don’t just watch the short interest, pay attention to the story behind the stock.

    If you had just seen the ~13% short interest in VW, you would have assumed this was at a normal level and would not cause too much trouble. But if you dug deeper and understood the story of the company and who owned it, the notion that the free float was magnitudes smaller may have revealed itself early.

The Long and Short of It

By no means take this as an indication that an investor should immediately go out and buy call options on their favourite oversold stock – most of the time if a stock is going down, there’s a good reason for it.

Unless you have a hedge fund, a group of impassioned retail traders, of a particularly ambitious car maker behind you, it’s a very risky play. Buying any security which you don’t understand is a dangerous strategy, and options are arguably some of the most difficult instruments in the market to effectively execute without the expertise and a refined strategy.

But understanding the mechanics of how this phenomenon has occurred is another tool investors can use to analyse market movements, understand the psychology behind a move and try to spot likely areas of risk.

Keep an eye on where the market is behaving irrationally or illogically – be it an impending short squeeze, or plain old information inefficiencies, recognising something before the majority is often an invaluable opportunity.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.