Investors beware on the market impact of a short squeeze

In early 2021, Wall Street began seeing high profile short squeezes. These are situations where investors coordinate purchases and drive up the price of certain stocks in order to force short sellers to exit their positions at a loss1. In the short squeeze of GameStop Corp. (GME) every day average Joe’s acted as retail investors and pushed back against the shorts placed against GME by the described “1% of Wall Street.” This event was fueled and backed by the popular Reddit forum, WallStreetBets. This forum allows career investors and the average person alike to come together to discuss hot topics in the trading market. This is where word of the large shorts being placed against GME came to the mainstage. From here, thousands of people rallied together to buy GME shares to drive up the price and cause the short positions to incur large losses. This rally, due to the nostalgic love these investors had for the company and to battle against Wall Street, led to a 1,600% increase in the GME stock price and has been marked as one of the most significant bull rushes in stock market history. The bullish run of GME stock was followed shortly after by a similar short squeeze on AMC Theatres (AMC), which benefited from the same driving factors as GameStop, with share prices spiking as much as 52%.

To understand why this caused such an uproar, it is important to understand short selling. Short selling is the investment strategy that speculates on the decline in a stock or other security’s price and can be used to hedge against the downside risk of a long position in the same security or a related one. This strategy tends to receive negative attention in the media under concerns that it is purely speculative and potentially destabilizing for markets. Yet it plays an important role in efficient capital markets by facilitating secondary market trading of securities and positively impacting corporate governance and the economy. The current information age has presented new challenges for short sellers. With information more readily available about short positions that companies hold, it allows for others to determine which companies, like GME and AMC, have large short positions held against them. While some may speculate this is a coincidence or a fluke, the possibility of this becoming a more common occurrence is an increasing threat to short sellers around the world.

While the story behind the historic rise of GME and AMC stock was something to marvel at, events like these introduce additional risks for short sellers. One of the biggest risks feared on Wall Street after the GME and AMC short squeezes is the threat of market manipulation. This happens when there is abuse in the market or a deliberate attempt to interfere with free and fair operation of the market, including the apparent misleading of a stock’s true value. The aforementioned short squeeze showed the possibility of how severely the market can be manipulated due to the power of the crowd. Wall Street analysts believed that the historic rise of the value of these stocks was not representative of the true value of them, but instead the effect of the crowd rallying behind them.

One of the risks associated with market manipulation is certain investors partaking in pump-and-dump operations. A pump-and-dump is the act of a small group of investors promoting a low-priced stock that they already own to inflate the price in order to sell their holdings at a high profit. Upon selling the stock, the promotion dies out, and the price drops to normal levels. When this occurs with a significant volume of shares it can lead to a substantial impact on the market5. This situation can cause significant losses for investors who buy after the promotion of the stock has hit its apex. Due to the potentially devastating impact, this type of practice has been deemed illegal based on securities laws.

When situations arise that lead to sizable gains or losses that are not based on facts, there is potential for additional regulations that could impact the accounting and finance around these types of transactions. While there have been no new laws or regulations enacted to address this issue, these events could cause potential challenges for accounting, investing and advisory industries going forward. The GME and AMC short squeezes have brought to the forefront how the markets can be swayed by unpredictable or previously unseen events. These events have introduced new risks to consider for investors and traders and how they advise their clients. While in the long run the effects may be minimal, if there is anything that can be taken away from this, it is that anything can happen in an unpredictable market.