Short squeezers could end up strangling themselves

Business

Short-squeeze mania is spreading. The strategy, favoured of late by U.S. retail traders, boosted heavily shorted European stocks on Wednesday. The immediate victims are bearish hedge funds who didn’t see it coming. But the squeezers themselves also risk overreaching.

Shares in Klepierre, Unibail-Rodamco-Westfield, Ambu and Pearson were up 13% on average by mid-morning. They’re among the most heavily shorted stocks in Europe, according to a list compiled for trading clients of a major investment bank seen by Breakingviews.

It’s similar to a recent U.S. phenomenon, as exemplified by surging video-game retailer GameStop. Amateur traders, often coordinating through online message board Reddit, buy options in well-known shorts, forcing bank market makers to cover their position by purchasing the underlying shares. That pushes the price even higher, and eventually hedge funds who have sold the stock on loan have to buy to limit their losses. GameStop’s share price has roughly quadrupled in the past five days. It’s possible that some investors are now hopping on the same trend by snapping up shares in perennial shorts.

Bearish hedge funds will be smarting even more than they already were. Research outfit S3 Partners reckons U.S. short positions made $245 billion of mark-to-market losses in 2020, including financing costs. That implies a minus 26% return on the average aggregate short position throughout the year. Investors even seem to be going after individual hedgies like Melvin Capital Management, which was previously shorting GameStop. Its other positions like Evotec, Varta and CD Projekt have surged in recent days.

Yet the squeezers could eventually feel the pain themselves. Forcing up the price of shorted stocks works best when there is a high degree of coordination between the buyers and relatively thin liquidity. As the number of targets spreads, the former gets harder. Targeting larger firms like Finland’s $27 billion Nokia, another Reddit favourite, also makes it harder to corner the shares. Retail squeezers and their institutional imitators could buy up heavily shorted stocks but then lack the heft to force prices up. Most of these companies are shorts for a reason: they may have questionable growth prospects or governance. Squeezing too hard risks self-asphyxiation.