Over the past few days, the price of Gamestop (GME) has dropped and according to many reports, the level of hedge fund short interest has fallen sharply.  Or has it?  This blog goes over what is going on and helping you answer the question of is the squeeze over.

On Monday, Feb 1, Bloomberg reported that “GameStop Short Interest Plunges in Sign Traders Are Covering.”  Several separate research firms, IHS Markit and S3 Partners, also reported something similar with a big drop in short-interest.  Since this coincided with the large drop in the value of GME shares, this would seem to be evidence that the hedge funds are winning, and the Reddit army is losing.  Look deep enough though and there seems to be some manipulation is how the short interest data is being reported and also possibly how hedge funds are “covering”.

Essentially, the issue at hand revolves are shorting practices and the concept of “naked shorting”.  I think most people understand that “naked shorting” is illegal, and it is – sort of.  The problem is that there are several gray areas where it is not so much a violation of the law but more of a minor infraction like a speeding ticket.  There is a legal way for certain parts of the market to short a stock beyond 100% of the float because they are supposed to be providing liquidity to the process.

Based off of the declining price in GME, we really have 2 possible conclusions.  Either GME squeezers lost their discipline and enough people started selling to get profits, thereby allowing hedge funds to cover their shorts by buying back the shares.  The other possibility is that the hedge fund short interest didn’t really go away.  The tactics that the hedge fund could have employed are not a secret and the SEC published a “risk alert” memo on the topic in August 2013.  The SEC memo is titled “Strengthening Practices for Preventing and Detecting Illegal Options Trading Used to Reset Reg SHO Close-out Obligations.” You can read it here via the SEC website.

There’s a lot of detail in this document but essentially, hedge funds can use tricks to make it look like they have covered their shorts by exploiting certain loopholes that exist due to an interplay of reporting rule delays, market maker naked shorting exceptions, and legal practices of synthetic share creation (new longs and shorts made from thin air) relating to market-making.

The GameStop squeeze is a unique scenario, however, because it is a very public fight to the finish between the Reddit army and the hedge funds that are short.  In a battle like that, with public coverage influencing both sides, perception is a weapon. As such, if the hedge funds can generate the appearance of having covered most of their shorts, while driving down the GME share price through aggressive selling on low volume (something known as a “short ladder attack”), then the hedge funds increase their odds of breaking the squeeze — in part because media outlets will report things like “GameStop Short Interest Plunges” without looking deeper.

To be clear, it is also possible the first scenario is true and people caved.  GameStop shares may have fallen precipitously, with hedge fund short interest falling alongside, because a critical mass of long GME holders simply lost faith and tried to sell before the squeeze was complete.

I have my own opinion on the matter but as with everything we teach, it’s up to you to do your own due diligence and make your own decisions.  But at this point you should have a better gut instinct one way or the other for the question of is the squeeze over?

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