Investors are always on the lookout for lower-priced stocks that they can invest in. The stock prices of companies can be a major hindrance for retail investors with a limited amount of capital. For example, in order to buy one stock of Amazon, investors need to shell out close to £2,500.
Comparatively, investing in penny stocks might seem like an ideal alternative given the lack of capital. While penny stocks have the potential to grow at a rapid pace they also carry significant risks. Generally, stocks that are priced under £10 can be considered penny stocks.
While large-cap giants are highly liquid, low trading volumes for penny stocks make them vulnerable to price manipulations. These risks came into focus when a group of millennial investors on Reddit took Wall Street by storm last month.
The Reddit group known as wallstreetbets implemented a short squeeze strategy on a hedge fund. A short squeeze takes place when a stock gains in market value which forces bears (who bet that the stock price will fall) to buy the stock and limit their losses.
In the event of a short squeeze, the price of the stock accelerates at a rapid pace which leaves short-sellers with no option but to buy the asset at a higher price.
What happens in a short squeeze?
Generally, there are multiple factors that could cause a move in a company’s stock price in the near-term. It can be due to a major announcement or even a quarterly earnings report. Basically, if there are more buyers than sellers, the stock price will move higher and vice versa.
Now, a short squeeze is experienced when a stock has a lot of short-sellers that bet against the company. The data regarding a stock’s short interest is easily available and can even be viewed in your broking account.
Short interest is updated each month and investors can look at the percentage of shares sold short with respect to the total available outstanding shares. For example, if a company has a float of 100 million shares and 10 million shares are currently sold short, the short-interest will be 10%.
So why do hedge funds and other traders with a short position frantically cover their positions in a short squeeze? In case a hedge fund shorts 100 shares of a stock at £$10 a share, the maximum profit will be limited to £2,000 in case the stock falls to zero. However, in case the stock gains momentum and reaches £40, short-sellers stand to lose £4,000.
So while the profit is limited the losses are theoretically unlimited. That’s why hedge funds were desperate to buy GameStop stock after taking a short position earlier.
GameStop’s wild ride
GameStop was arguably the most talked-about stock in January after it rose from $17.25 at the start of the year to a record high of $483 on January 27. It has since lost 80% in market value but has still returned over 400% year-to-date.
GME was a penny stock when it touched a 52-week low of $2.57 per share last year just after the COVID-19 pandemic induced sell-off decimated equity markets. GameStop is a video game retailer and has been grappling with falling sales and declining profit margins due to the shift towards digital gaming.
At the end of December 2020, 260% of GameStop’s float had been sold short which means GME shares have been borrowed 2.6 times on average. It shows an overwhelming majority of shareholders were betting against the company. However, the short squeeze executed by the Reddit group meant GME experienced a rip-roaring rally in just a few trading days.
Last month, GameStop shares increased in value by over 50 times compared to its market cap in August 2020 when it was trading at below $5. What investors should note that GameStop remains a fundamentally weak company. Between February 2016 and January 2021 its shares declined by 80% as its business model was massively disrupted.
AMC was another penny stock that sky-rocketed
Another stock that was part of a short-squeeze recently was AMC Entertainment. Shares of the beleaguered entertainment company gained almost 10x between the start of the year and January 27. It has since lost over 60% in market value which emphasizes the risks involved in trading penny stocks.
In the last few days, beaten-down companies such as Nokia and American Airlines have also come under the Reddit radar, experiencing a spike in their stock prices. While the short squeeze has had Wall Street in a tailspin, you can see how stocks remain vulnerable to manipulations in the short-term and no amount of due diligence can save you from market sentiment or investor activism.
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