The Mechanics of the Short Squeeze Explained

The Mechanics of the Short Squeeze Explained
Porsche, Herbalife and the VIX — a luxury carmaker, a nutritional supplement company and a market volatility index are the latest examples of short squeezes involving hedge funds. In a short squeeze, the price of a stock is driven sharply higher as a large number of short sellers attempt to cover their positions at the same time. Short sellers by definition have a bearish outlook on a stock and only make money when the stock price declines. While the upside potential is limited to the stock price going down to 0, the downside risk is unlimited, as theoretically there is no limit for how high a stock can rise. It is this risk that leads to short squeezes.  If there is a rapid rise in the price of a stock short sellers are likely to want out of their positions quickly. In the end a short squeeze is a supply and demand phenomenon; the supply for a stock is limited but there is excess demand for the stock as short sellers clamor to exit their positions, causing the price of the stock to rise even higher. In the middle of 2005, Porsche announced its plans to acquire a 20 percent stake Volkswagen (VW), the German automaker that sells 60 times more cars than Porsche according to Automobile magazine. However, by October 2008 Porsche disclosed that it had acquired a 75 percent stake in VW, more than its previously disclosed plans. This caught a group of hedge funds including the likes of Elliott Associates, Viking Global Equities and Glenview Capital Partners who had placed bets against Volkswagen, by surprise. Over the course of 2006 to 2008 the shares of VW had risen to levels that did not justify a deal in the minds of the hedge fund managers and they shorted VW shares believing Porsche had stopped its share purchases. Instead following the announcement by Porsche, the shares of VW spiked forcing the funds to incur huge losses as they tried to cover their short positions — a classic example of a short squeeze. The hedge funds have accused Porsche of misleading investors and have filed suits in Germany to recover some damages. The story that has garnered a lot of attention lately and has intrigued many in the investment community is the story of Herbalife. Bill Ackman of Pershing Square Capital Management accused Herblife of being a pyramid scheme during a presentation in December 2012 and is short nearly 20 million of the company’s shares to the tune of $1 billion. On the other side of the trade are Carl Icahn and Dan Loeb who have both accumulated equity stakes in the company. Ackman has already survived one short squeeze. According to a report by Reuters, the shares which were down 40 percent following Ackman’s presentation surged 76 percent from December 24 to January 15. The report also highlights one important advantage that Ackman has, whereas most investors use loans to borrow shares from a broker, Ackman has built his short position using cash, making it more likely that he can hold his short position longer than the average short investor and more likely that he can survive another short squeeze. Short squeezes are not limited to stocks however; many are talking of a potential for a short squeeze in the futures market for the VIX. The VIX, is an index that was introduced by the Chicago Board of Options Exchange (CBOE), measures the 30-day volatility expected by the market. According to the Commitment of Traders (COT) report published on the Commodity Futures Trading Commission’s website, speculators are net short the VIX futures contract 2:1. Meaning there are twice as many short positions than there are long positions. Though a short squeeze in the VIX has not yet materialized, it is still remains a risk. Short selling plays an essential role in the market but it is not for amateurs or the faint of heart, one must always be weary of the risk of being squeezed out of short positions – and hedge funds and sophisticated investors are not immune from the repercussions of a short squeeze.