When “short squeeze” meets “HODL” and “number go up”

Decorational image showing generic finance-looking stuff.
Licensed under CC-BY-ND 4.0 International from QuoteInspector.com

Let me drastically oversimplify the situation compared to real life.

Suppose that there are 5 shares total, and there are 5 investors who each own one share: A1 through A5. For the sake of simplicity, we’ll say that all investors in category A believe that the stock is worth buying at $800/share and worth selling at $1000/share. They are currently holding, therefore the share price must currently be below $1000/share.

Now imagine that there is a second class of at least 5 investors, B1 through B5, who all believe that the stock is worth buying at $400/share and worth selling at $500/share. As the story begins, they own zero shares, which implies that the share price must currently be above $400/share.

Now also imagine a third class of at least 2 investors, C1 and C2, who all believe that the stock is worth buying at $200/share and worth selling at $250/share. Again, they own zero shares.

There are no trades currently happening, so the “share price” is really a fiction. The ticker symbol probably just advertises the price of the last transaction, I would guess. Let’s say it’s $800/share, the highest price that A1-A5 would have bought at.

Now in comes the short seller, S. S believes that the true value of the stock is much lower than $800/share, perhaps $150/share or lower. They ask A1-A5 to loan their 5 shares of stock to S for $100/share.

Now S owns 5 shares and -$500, while A1-A5 each own $100 and an IOU for one share. The “share price” is still $800/share, since no sales have taken place yet.

Note: the total number of IOUs is 100% of the number of shares.

S now puts the 5 shares up for sale, dropping the price repeatedly until it reaches $400/share. At that point, B1-B5 snap it up.

Now S owns $1500, A1-A5 each own $100 and an IOU, and B1-B5 each own 1 share and -$400. The “share price” is $400/share.

S thinks the price can go lower because there are no more investors in class B. They ask B1 and B2 to loan their 2 shares of stock to S for $50/share.

Now S owns 2 shares and $1400, A1-A5 each own $100 and an IOU, B1 and B2 each own -$350 and an IOU, and B3 through B5 each own -$400 and one share. The “share price” is still $400/share.

Note: the total number of IOUs is 140% of the number of shares.

S now puts the 2 additional shares up for sale, dropping the price repeatedly until it reaches $200/share. C1 and C2 snap it up.

Now S owns $1800, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and an IOU, B3-B5 each own -$400 and a share, C1-C2 each own -$200 and a share. The “share price” is now $200/share.

What S expects to do at this point is this: S will wait until the category C investors get frustrated with no one willing to buy the stock at $250/share. Assuming the category C investors were hoping to cash in on the next idiot, rather than holding the stock because they believed in its long-term value, they will eventually drop their asking price below $200/share to whatever price S is willing to buy at. Suppose S is willing to buy at $150/share; when C1 and C2 reach that price, S snaps up those two shares, and uses them to fulfill the IOUs to B1 and B2.

Now S owns $1500, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and a share, B3-B5 each own -$400 and a share, C1-C2 each own -$50. The “share price” is now $150/share.

Then S repeats the process with the category B investors, eventually waiting for them to give up and sell their shares for $150 as well, using them to fulfill the IOUs to the category A investors.

Now S owns $750, A1-A5 each own $100 and 1 share, B1-B2 each own -$200, B3-B5 each own -$250, C1-C2 each own -$50. The “share price” is still $150/share.

At this point, S is free of all outstanding obligations, so they get to pocket the $750. Short selling made a profit for them.

Now, let’s rewind a few paragraphs and introduce Reddit.

Reddit, for those who don’t know, has a lot of people who very fervently believe in cryptocurrencies like Bitcoin. The Bitcoin mantra is “number go up”: nevermind that you can’t actually spend Bitcoin on anything, or use Bitcoin as a resource to make a product, or any other activity which would produce a net economic gain. You buy and hold because the price will go up, and the price will go up because other people are buying and holding.

Enter /r/wallstreetbets.

These “category R investors”… well, not all of them are cryptocurrency junkies, but cryptocurrency memes are definitely a lot more familiar to them than said memes are to other types of investors. As such, they aren’t scared of buying and holding — not nearly as scared as they probably should be. And some of them don’t even care about making a profit; they just want to screw the short seller! So they are willing to buy at a ridiculously high price, e.g. $2000/share, just to make S suffer and make the share price shoot to the moon.

So R1 buys 2 shares from C1-C2 for $250/share and 3 shares from B3-B5 for $500/share.

Now S owns $1800, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and an IOU, B3-B5 each own $100, C1-C2 each own $50, and R1 owns -$2000 and all 5 shares. The “share price” is now $500/share.

Reddit is a wild place, and people keep bidding up the stock. R2 buys all 5 shares from R1 for $2000/share, with the intent of selling for $2001/share.

Now S owns $1800, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and an IOU, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, and R2 owns -$10,000 and all 5 shares. The “share price” is now $2000/share.

At this point, everyone who has an IOU starts to panic, because they believe the stock is wildly overpriced. Thankfully (for them), built in to the loan was a clause that, if the stock price went above some fixed number, the loan would become due immediately. This has now happened. S is now screwed.

S now has to buy all 5 shares back immediately, but the only investor holding shares is R2. They pay R2’s ransom, $2001/share, just to get the shares back.

Now S owns -$8,205 and 5 shares, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and an IOU, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, and R2 owns $5. The “share price” is now $2001/share.

S is caught in a bind: they own all 5 shares, but they have to pay out 7 shares worth of IOUs. The only way they can handle this is to give the shares back, then wait for them to go back on the market and re-buy them.

At this point it doesn’t really matter whether the shares go back to category A or category B investors; either investor category is going to see that $2001/share price and demand an equal ransom. Let’s unwind the category B IOUs first.

Now S owns -$8,205 and 3 shares, A1-A5 each own $100 and an IOU, B1-B2 each own -$350 and a share, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, and R2 owns $5. The “share price” is still $2001/share.

And now S buys the shares back from B1-B2.

Now S owns -$12,207 and 5 shares, A1-A5 each own $100 and an IOU, B1-B2 each own $1,651, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, and R2 owns $5. The “share price” is still $2001/share.

And now S unwinds the obligation to category A.

Now S owns -$12,207, A1-A5 each own $100 and a share, B1-B2 each own $1,651, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, and R2 owns $5. The “share price” is still $2001/share.

And now the category A investors sell to category R.

Now S owns -$12,207, A1-A5 each own $2,101, B1-B2 each own $1,651, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, R2 owns $5, and R3 owns -$10,005 and all 5 shares. The “share price” is still $2001/share.

Now imagine that the fad burns out, and the category R investors want their money back. Unfortunately, category R investors were the only ones keeping the share price so high, and there’s no R4 willing to buy at a higher price anymore. R3 repeatedly drops their asking price until, finally, the category A investors are willing to buy in at $800/share again.

Now S owns -$12,207, A1-A5 each own $1,301 and a share, B1-B2 each own $1,651, B3-B5 each own $100, C1-C2 each own $50, R1 owns $8000, R2 owns $5, and R3 owns -$6,005. The share price is once again $800/share.

Basically, R1 → R2 → R3 is a (possibly?) unintentional pyramid scheme: early adopters cash out from the deposits of late adopters, and the late adopters are left holding the bag. R2 and R3 would have done well to be skeptical of R1.

What’s more, most of the Redditors are using Robin Hood, a service which sells early access to your transactions to a category of hedge funds known as “flash traders”. Basically, if you tell Robin Hood “I want to buy stock X at price Y or lower”, the flash traders will be permitted to see your transaction before it’s allowed to complete, and in the milliseconds between when you click “OK” and when your transaction completes, they can execute their own transactions at higher priority than yours. Basically, the flash traders (1) buy X for Y minus delta, (2) sell X to you for Y, then (3) pocket the delta.

In the early phases of the Reddit swarm, where the price spread was wide between what most investors thought the stock was worth and what Reddit thought the stock was worth, flash traders must’ve made bank at the expense of the Redditors.