The Recent Short Squeeze Phenomenon
Market Overview
The market has witnessed yet another volatility event in January 2021 amidst the low liquidity environment that Capstone has been highlighting. The VIX index jumped from a low of 21.27 on Friday, January 22nd, to as high as 37.51 on Wednesday, January 27th, a day with a more than 14-point jump alone.
Market volumes were extraordinary, with the highest rolling 5-day equity volume in the US since at least 2008. This particular event was catalyzed by the well-publicized short squeeze of small-cap stocks that was ostensibly executed by retail investors who coordinated over the online social media platform, Reddit. Most notably, GameStop gained nearly 1300% at its peak, rising from $35.50 on January 15th to as high as $483.00 on January 27th. Long/short equity hedge funds who were short these stocks experienced severe pain, as intended, and this led not just to short covering. Capstone previously noted historically high net and gross leverage from hedge funds, and with L/S equity funds forced to de-lever substantially during the short squeeze event, it resulted in long exposure being slashed and creating selling pressure. Goldman Sachs reported a 7.5% fall in hedge fund gross leverage as a whole in just one day and 10% over the week of January 25th in the largest active hedge fund deleveraging since February 2009. This overall deleveraging was driven by L/S equity unwinds, despite the upward pressure that the short squeeze mark-to-market placed on gross leverage. Even after the reduction, Capstone believes hedge fund leverage remains quite high. It remains unclear how much de-leveraging is still required or how long it will continue. So far, though, it has been largely contained to a small segment of the market with no signs yet of major contagion, even including the implied effect on the exposures of volatility target strategies.
In an already illiquid market, the unwinds’ effect, even if contained to one segment of the market, was amplified with the largest impact on crowded longs and heavily shorted names. The left chart below shows the difference between an index that tracks the performance of equities strongly favored by hedge funds and an index that tracks heavily shorted names. The heavily shorted names outperformed the long names by over 31% from January 21st to January 27th. January 28th proved to be a day of respite for hedge funds as brokers like Robinhood restricted purchases of GameStop, which then lost nearly half of its market cap. Friday was another painful day as the small-cap stocks rebounded, the general market fell and unwinds continued.
It is also important to note that retail options activity was another driver of market activity. The already extreme retail activity and single name call buying accelerated in January; this drove prices higher and put dealers to short gamma in certain names. As market levels of those specific single names rose, the short gamma positioning forced dealers to buy the underlying shares to hedge their positions. This activity further amplified the moves higher. Capstone also witnessed a rising demand for implied volatility in days before the realized volatility emerged. However, the market generally fell over the week of January 25th, which reduced the dealers’ short gamma in the broader universe of stocks.
It remains to be seen whether this event is over or if market parameters normalize from these levels rather than see a continuation or knock-on effects. Either way, Capstone believes the market will continue to see events like this given the low liquidity and high valuations environment, coupled with heavy and crowded positioning.
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Reference to Instruments and Indices:
References to indices are included for illustrative purposes only and are not intended to apply that any Capstone fund or account is similar to such index in composition or element of risk.
The S&P 500 Index (SPX) consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The CBOE Volatility Index (VIX) is based on real-time prices of options on the S&P 500 Index and is designed to reflect investors’ consensus view of future (30-day) expected stock market volatility.
Goldman Sachs Hedge Fund VIP Index (GSTHHVIP) is designed to deliver exposure to equity securities whose performance is expected to influence the long portfolios of hedge funds. The Index consists of hedge fund managers US-listed stocks whose performance is expected to influence the long portfolios of hedge funds.
Goldman Sachs Most Shorted Rolling Index (GSCBMSAL) is an equally weighted basket of the 50 highest short interest names in the Russell 3000. Each name in the basket have a market capitalization greater than $1billion and is updated monthly.
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