Jargon Junction: Short Squeezes

In an issue published on December 6, 2024, I detailed the nonsensical mechanics of short selling. I accomplished this extraordinary feat by creating a propriety case study which included a bogus “AI” company called Rent Seeking Analytics, a techno-libertarian douchebag named Peter Thiel, and a broken business model built around annual paid subscriptions lol!

In today’s edition of Jargon Junction, I’m detailing one of the biggest risks traders face when shorting a stock: a so-called short squeeze.

Note: For space and clarity, I won’t rehash all the gory details of the original case study. To fully understand the following example, I suggest reading or reviewing the previous edition of Jargon Junction by clicking HERE.

Recall in our case study we’d shorted 100 shares of Rent Seeking Analytics stock at $100.00 per share. We pocketed $10,000 from this transaction and, based on our short thesis, we expected RENT’s market price to decline to $60.00 per share after reporting dogshit earnings.

Had this scenario played out, we would’ve booked a $3,500 profit (e.g., we would’ve sold $10,000 of borrowed shares, bought back $6,000 of shares in the open/secondary market, and paid our broker Davos Man Inc. $500 in “borrowing” costs; or $10,000 - $6,000 - $500 = $3,500).

Let’s now imagine a situation where, unfortunately, our original bet backfires. For example, assume during Rent Seeking Analytics’ quarterly investor call, rather than simply reporting dogshit earnings due to its fundamentally broken business model, the dystopian tech firm shocks its investors by announcing a strategic partnership with a plucky little online bookstore called Amazon.com.

Pretend, per the transaction terms, Amazon plans to acquire a 40% equity stake in Rent Seeking Analytics and the two companies also announce an unexpected joint venture: they plan to 1) leverage Rent Seeking Analytics’ “artificial intelligence” software to illegally collect purchasing and biometric data from Amazon’s customers and 2) sell this stolen data to online advertisers and government intelligence agencies. In other words, a business model which works.

What would happen to the market price of RENT after this announcement?

The partnership with and investment by Amazon would give “the market” confidence in Rent Seeking Analytics’ technology and signal a probable future acquisition by The House of Bezos. Both dynamics would cause RENT’s stock price to soar.

For simplicity, let’s assume RENT’s market price jumped from $100.00 to $150.00 on the news. This would be exceedingly bad for us, and also all the other traders who’d bet the fraudulent tech company was about to poop its pants.

Any- and everyone who’d shorted RENT stock would be forced to rush into the open/secondary market and buy back shares to “cover” their short positions and mitigate their losses.

If a significant number of punters had made the same bet we had — highly likely owing to the “efficiency” of the market — then a bunch of glorified gamblers (including us) would need to buy RENT shares at the same time. Of course, everyone’s aggressive buying in the open/secondary market would increase the demand for available shares, reduce the supply of available shares, push the stock price higher, and exacerbate the losses suffered by short sellers.

When a shitload of short sellers all need to buy stock at the same time to cover their bets gone bad, the phenomenon is called a “short squeeze,” and the financial damage can be catastrophic.

In our case, we’d be forced to purchase 100 RENT shares at $150.00 per share — for a total expenditure of $15,000 — and return those shares to Davos Man Inc., the broker where we originally borrowed them. When all was said and done, we’d be looking at a $5,500 loss (e.g., we sold $10,000 of borrowed shares, bought back $15,000 of shares in the open/secondary market, and paid Davos Man Inc. $500 in “borrowing” costs; or $10,000 - $15,000 - $500 = -$5,500).

Mercifully, this concludes our short selling module. I know these past two editions were painful, but this information will serve you well as both reader of Leverage and observer of modern-day financial madness.