For real-time updates, do join our:

1. Telegram Group: t.me/theinvestquest (or search “The InvestQuest” on Telegram)
2. Whatsapp Broadcast: Just send “Hello IQ” to +65 8840 2520
3. Facebook Page: The InvestQuest | Facebook
4. LinkedIn Page: The InvestQuest | LinkedIn

---

---

1) The most heavily shorted US stocks have performed really well the past year

2) However, longer-term risk-adjusted returns still favours the S&P 500

3) Two reasons why heavily shorted US stocks have rallied recently

4) Stock screen to identify the next GameStop and AMC Entertainment

---

The InvestQuest View

Despite the recent outperformance, we DO NOT believe that buying the most heavily shorted stocks has proven to be a good investment over the longer-term historically.

However, we concede that investment flows are what dictate short-term stock price movements. Hence, we have screened a list of the most heavily-shorted US stocks, which may benefit should Reddit’s WallStreetBets phenomenon persist.

Disclaimer: As always, DO NOT take this article and the following stock screen as investment advice or as a recommendation in any form. We are NOT recommending you to buy these stocks. Should you choose to buy these heavily shorted stocks, beware that it is highly risky and it is possible you may lose all or most of your principal. As always, do your own due diligence when you make investment decisions.

---

1) The most heavily shorted US stocks have performed really well the past year

If you have been following financial markets in the past few weeks, you might have noticed headlines that the share prices of some of the most heavily shorted US stocks such as GameStop Corp and AMC Entertainment have been going ballistic. For context, if you had invested in GameStop since July 2020, you would have made a gain of 7900%.

This is a phenomenon that has been happening in a big way since October 2020, though we shouldn’t be that surprised given that we had other instances of “irrational” investor behaviour earlier on – remember what happened to Hertz share prices in June 2020 after it filed for bankruptcy?

In chart below, we show evidence of this phenomenon on a more macro level. The chart shows the price performance of the S&P 500 Index at +16%, versus the price performance of the “most heavily shorted” Russell 1000 Index stocks at a whopping +70%, since the start of 2020. Do note that the Russell 1000 Index includes the largest 1,000 US stocks, so they are still billion-dollar market cap companies that we are looking at.

---

2) However, longer-term risk-adjusted returns still favours the S&P 500

While it is easy to be caught up in the buying frenzy, it would be prudent to check if buying the most heavily shorted stocks have been a good strategy historically.

In the chart below, we show the price performance of the S&P 500 Index at +78%, versus the price performance of the “most heavily shorted” Russell 1000 Index stocks at +76%, since 27 February 2015 (index inception of the latter).

While the historical performance is roughly similar, there are two major points to highlight for the “most heavily shorted” Index:

1. Timing of returns is very uncertain. There was a prolonged period of underperformance, with bulk of the returns only occurring during the past year.
2. It is 60% more volatile than the S&P 500. The annualized volatility in the past 162 weeks is approximately 36%, versus 22% for the S&P 500.

From our above analysis, we believe that buying the most heavily shorted shares has not proven to be a good investment over the longer-term.

---

3) Two reasons why heavily shorted US stocks have rallied recently

The two reasons we often see being quoted in the news is “short squeeze” and “gamma squeeze”. We will explain what they are and how they have both contributed to the recent rally.

What is a “short squeeze”?

• For example, imagine that Stock A is currently trading at $10.
• You have a negative view on Stock A, thinking that its true value should only be $5, hence you sold it short at $10 per share (this is typically done on margin). If the price of Stock A falls, you would buy back the share and make a profit, and vice versa.
• However, instead of falling in price, Stock A price jumps to $15. Your unrealized loss is now at $5 per share. Very painful but you decide to hold on.
• Stock A continues to rally in price, and is now at $30. You are now making an unrealized loss of $20 per share and your collateral with the broker has been totally wiped out. You are now forced to cover your position by unwinding your short position (by buying Stock A).

The act of being forced to cover your short position is what is known as a “short squeeze”.

This is what is happening to hedge fund managers like Melvin Capital, Citron Research and Point72, right now, as they are forced to cover some of their short positions.

Losses from short positions is theoretically unlimited. When you buy a stock, your maximum loss would be simply 100% of how much you paid for the stock. However when you short sell a stock, for example when Stock A was at $10 using the above example, you realize that when the stock goes to $30, your loss is actually 200% of the initial stock price. Using an the extreme scenario, recall that GameStop’s share price is now 80x that of July 2020.

What is a “gamma squeeze”?

Increasingly we have also been seeing retail investors speculating using stock options, especially call options which bet that stock prices would rise.

When an investor buys a call option, the option premium might cost only a few percent of the option’s face value.

• For example, Apple stock last closed at $142.06.
• An investor who is bullish on Apple can buy a call option (let’s assume a strike price of $142 and the option matures on 19 Mar 2021), which costs $11 or approximately 7.7% of Apple’s current stock price.

A market maker (a financial institution) typically takes up the other side of this trade. The job of the market maker is not to bet on where the market is headed, and will typically hedge out the position.

• To hedge the investor’s call option purchase, the market maker buys Apple stock, the amount of which is typically the “option’s Delta” multiplied by the face value of the call option.
• “Delta” is a measurement of the price sensitivity of the option, relative to changes in the stock price. A “Delta” of 0.5 would mean that if the stock price increases by $1, the call option price would increase $0.50.
• At-the-money options typically have a delta of 0.5. Hence, to hedge the above Apple call option, the market maker would likely have to buy $71.03 ($142.06 * 0.5 delta) worth of Apple stock, an amount that is even greater than what the investor paid for to buy the call option!

As more Apple call options are purchased, the more market makers have to buy Apple shares to hedge the position, driving up Apple stock price further.

• As Apple Stock price increases, there is a higher likelihood that the Apple call options will mature in-the-money. As a result, there will be an increase to the call option’s “Delta”.
• The rate of change of the option’s “Delta” relative to a change to the stock price, is what is known as “Gamma”.

During a “Gamma squeeze”, what happens is that a stock price increase triggers an accelerated increase in the “Delta” of outstanding call options. Market makers then have to buy more of the stock to hedge their position, resulting in a positive feedback loop that drives the stock price even higher.

---

4) Stock screen to identify the next GameStop and AMC Entertainment

As mentioned earlier, we DO NOT believe that buying the most heavily shorted stocks is a sound long-term investment strategy. However, if we were to pre-empt what could possibly be the next stock target on Reddit’s WallStreetBets, I would probably look at the following criteria:

1. Most heavily shorted US stocks (>30% short interest as % of free float, so that a meaningful short squeeze can occur)
2. Have listed options (so that a meaningful gamma squeeze can occur)
3. Market cap >US$100M (large enough to have sufficient trading liquidity to take a position but small enough such that retail investors can trigger a short squeeze and gamma squeeze)

Disclaimer: This article and the above screen are in NO way a recommendation for anyone to buy any of these securities. As always, do your own due diligence when it comes to investing.

---

The InvestQuest View

Despite the recent outperformance, we DO NOT believe that buying the most heavily shorted stocks has proven to be a good investment over the longer-term historically.

However, we concede that investment flows are what dictate short-term stock price movements. Hence, we have screened a list of the most heavily-shorted US stocks, which may benefit should Reddit’s WallStreetBets phenomenon persist.

Disclaimer: As always, DO NOT take this article and the following stock screen as investment advice or as a recommendation in any form. We are NOT recommending you to buy these stocks. Should you choose to buy these heavily shorted stocks, beware that it is highly risky and it is possible you may lose all or most of your principal. As always, do your own due diligence when you make investment decisions.