Short sellers play a dangerous game.
Several Wall Street hedge funds recently learned that the hard way when they were nearly wiped out by a short squeeze that was orchestrated by investors in the Reddit community r/WallStreetBets.
Here’s how it happened.
As you might already know, when short sellers believe that a stock is going to fall, they’ll take a short position by borrowing shares and immediately selling them, in the hopes of buying them back later at a lower price.
When the shares are eventually returned to the lender, the short seller can net a profit between the sold price and the repurchased price.
Unfortunately, this strategy can backfire… badly.
Theoretically, the risk of loss on a short sale is unlimited because the price of any asset can climb to infinity.
If the price of a stock rises, short sellers will start to amass unrealized losses. And if the stock continues to rise, short sellers may be forced to close their positions to avoid even greater losses.
So what happens next?
When the panic sets in, short sellers will buy in desperation at whatever the market price is.
This only adds more fuel to the fire as a cascading effect of buy orders creates what’s known as a short squeeze - the phenomenon where more buying causes share prices to spike - which causes more shorts to cover - which causes shares to spike - which causes shorts to cover, and so on… and so on…
This is exactly what happened to Wall Street hedge funds Melvin Capital, Viking Global Investors, and D1 Capital Partners when shares of GameStop (NYSE:GME) spiked to record highs earlier this year.
In fact, analytics firm S3 said GameStop short sellers had mark-to-market losses of nearly $20 billion by the end of January 2021.
On the flipside, the retail investors that built long positions on the opposite side of the trade have achieved cult status for nearly wiping out several Wall Street hedge funds.
It is perhaps one of the greatest David versus Goliath stories written.
Of course, now investors want to know which heavily shorted stocks are the most vulnerable for the next Reddit short squeeze.
To help you get started, these are the stocks that currently have the highest short interest that could spike higher if retail investors band together to take on Wall Street again: