The short squeeze of death

Posted: January 8th, 2009 | Author: Wayne Weddington | Filed under: Opinion | Tags: hedge funds, short selling, Strategy |  Email This Post Make a Comment »

On Tuesday, Adolf Merckle threw himself in front of a train.

Merckle committed suicide on Tuesday January 6 2009 in the face of a crumbling financial situation.  The German billionaire’s speculation in Volkswagen stock pushed his business empire to the edge of ruin.  Last Fall, Mr. Merckle lost hundreds of millions of euros in a speculative battle with Porsche, the sports car manufacturer, to seize control of Volkswagen. Mr. Merckle had lost a sizable bet that shares in Volkswagen would fall, in a financial transaction known as short-selling. The loss of “the low hundreds of millions” does not seem a huge loss compared to an estimated net worth of $9.2 billion (Forbes 2008). But the agony of defeat at the hands of one of the decade’s most aggressive short squeezes proved too much to bear for Merckle.  He eventually took his own life.

I am not making light of Merckle’s suicide.  As pointed out by Douglas Faneuil on The Huffington Post “though often characterized as the result of some life event, [suicide] is nearly always caused by an underlying mental disorder… 90-95% of those who kill themselves exhibit clear and commons signs of mental illness well before their lives end. Certain tragedies… may trigger an acute depression, which can lead to suicide, but nearly all victims of suicide have… illness.”

Yet the event stands a macabre illustration to the perils of short selling – the short squeeze.  In Do-it-Yourself Hedge Funds I discuss short selling as one of the primary tools of the hedge fund manager but it is equally important to be aware of its perils.  A short is making a bet that the price of the security will decline by selling a security that you do not own. The objective is to buy it back at a lower price at a later date and make a profit. It is a “sell high, buy low” proposition for the investor, the opposite of the traditional “buy low, sell high” axiom—but it can be just as profitable. By selling a security short, you are literally borrowing it (usually from a bank or broker) at ostensibly no cost, and selling those borrowed shares in the market.

The lender to the short seller can call the stock loan at any time, potentially forcing the seller to purchase the stock at significantly higher prices.  Porsche made tens of billions dollars in profits from executing a brilliant tactical short squeeze.  Technically the potential loss on a short sell is unlimited whereas the potential gain is limited to 100% since stock prices can not decrease to less than zero.  Clearly the Porsche short squeeze case is exemplary and worth taking note.

The Porsche family brutally cornered the market in Volkswagen stock.  Porsche acquired a significant amount of VW stock in the open market just like anyone else.  Seeing that the fundamentals of the global car market would deteriorate, “savvy” short sellers, including Merckle, pounced and began short selling the stock thinking that the stock would collapse once Porsche stopped buying it.  But Porsche had a secret weapon.  Porsche subsequently revealed that it not only owned 42.6 percent of the stock, but that it had acquired call options for another 31.5 percent indicating a total ownership of close to 75 percent.

Porsche effectively controlled more shares than could exist on the open market, and then demanded that the short sellers return their borrowed stock. The only way the short-sellers could cover their positions – i.e. buy back the shares they sold – was to purchase shares in the open market…. but the only shareholder who had shares to sell is Porsche. Squueeeeeeze. Porsche basically set the market price at crazy high prices and made a fortune.

Once the squeeze set in, Volkswagen’s stock soared from 210 euros to as high as 1,005 euros a share in just two trading sessions. The spike bankrupted speculators and put many others in financial distress.  Among the known hedge funds that were large short sellers are two large American funds, Glenview Capital and Greenlight Capital.

Sell high, buy low – the short sell strategy – can be a profitable trade, but the short squeeze can be treacherous even in declining markets.  Always check the short ratio – days of share volume necessary to cover outstanding short positions – before shorting a stock. If it is greater than 2, be cautious.

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