Short squeeze

Have you ever tried to squeeze your toothpaste out of the tube? If so, you know that it’s practically impossible to squeeze out the last remains of the paste. A short squeeze is possible – as GameStop’s drama reminds us – and it’s a nightmare for all short-sellers.

So, what is a short squeeze? It’s a rapid jump in the price of a stock or other asset that squeezes out the short-sellers from the market, forcing them to buy back the shares. But the catch is that when they are forced to cover their positions, the price is pushed even higher, causing even more short sellers to capitulate.

To explain this, it’s important to understand what short selling is. Most investors “go long”, which means that they buy an asset in order to resell it later at higher prices. But short sellers sell first to buy back later at lower prices. Now, you may ask how can short sellers sell a stock that they don’t have. The answer: they borrow it from the brokers. They make money when the price falls and lose when the price goes up. If the latter scenario occurs, they have margin calls to transfer more money into the brokerage account. The more the price rises, the larger the margin calls and the stronger the squeeze. The only way to stop this process and cut losses, is to buy back the shares, but that only strengthens the upward pressure on the prices, causing a bullish frenzy.

This is exactly what happen in January 2021 with GameStop shares. Retail investors decided to coordinate their actions, via a Reddit forum, and bought a lot of the company’s stocks, thus causing the price to rise. As many shares had been sold short, the price increase led to significant losses and to a frantic rush to buy back shares. This covering of short positions only caused the price to increase even further. As a result of the short squeeze, the price GameStop shares rose from $17.25 at early January to $348 at the end of the month.

Short Squeeze in Gold

Is a short squeeze possible in the gold market? On the one hand, yes, it’s perfectly possible – and some analysts have been expecting it for years. Their argumentation is based on the divergence between paper gold and physical gold. You see, most investors trade paper gold, i.e., assets that reflect the price of gold while not actually being gold itself, such as, gold ETFs, etc. As long as most investors trade paper gold and simply roll their future contracts instead of taking delivery of physical gold, everything is fine. But if sufficiently many investors ask for physical delivery, the bullion banks – that are usually short gold – would have to buy bullion they don’t have.

In other words, the situation in the gold market is similar to fractional reserve banking. Just as commercial banks hold only a fraction of our money as cash in bank vaults, the bullion banks  hold only a fraction of gold in vaults in their physical form. Therefore, an increase in demand for physical deliveries could trigger a bank run and a short squeeze, leading to a rally in gold prices.

On the other hand, short squeezes are more likely to happen in stocks with small market capitalization and small floats (and with high short-interest ratio). GameStop was such a market. However, the gold market is much bigger, with a capitalization in the trillions of dollars. It is also a very liquid market – the average daily trading volume for gold ranks among the largest financial assets in the world. In 2017, it was almost $200 billion per day in over-the-counter transactions (e.g., in London market), futures, and ETFs.

Short Squeeze in Silver

A short squeeze in the silver market is more likely, as it’s smaller than the gold market (although still much larger than GameStop’s capitalization). This is why Reddit investors chose the silver market as their next place to squeeze the short sellers. They wanted to expose a shortage of supply and to push silver prices up.

And initially the retail investors succeeded – but only for a while. The price of silver rose from around $25 to $30 in a few days of coordinated buying. However, the price of silver quickly fell to around $26-27, as the chart below shows. So, the short squeeze did not succeed.

Short squeeze in silver

The attempt to exercise a short squeeze in the silver market in 2021 failed, as the silver market is quite big and liquid (at least relative to GameStop). The daily average volumes on Comex have been at almost $11 billion since the start of 2020, and money managers have actually had a net-long position on the metal since mid-2019, so there was not much to squeeze. In contrast, GameStop was one of the most-shorted stocks in the U.S. before the frenzy.

The short-lived character of the Reddit-driven rally in the silver market confirms the view that – contrary to the popular narrative – there is no systematic suppression of the silver prices. Big players (or a large network of retail investors) can exert some influence on silver prices in the short-run, but such fluctuations (or even aberrations) and coordinated market plays are something different than long-term manipulation.