Market Efficiency and Limits to Arbitrage: Evidence from the Volkswagen Short Squeeze

Short squeezes can also occur when the demand from short sellers outweighs the supply of shares to borrow, which results in the failure of borrow requests from prime brokers. This sometimes happens with companies that are on the verge of filing for bankruptcy. Short interest ratio (also known as days to cover) measures the days required for short sellers to fully close their short positions. The ratio is calculated by dividing the number of shorted shares by the average daily trading volume (ADTV).

Therefore, it became increasingly difficult for short sellers to acquire VW shares to cover their short positions when the share price started rising after Porsche’s press release. This in turn exerted increasing price pressure on VW’s stock and resulted in estimated losses of more than EUR 20 billion for investors that had entered into these short-sell trades. A short squeeze can last for several days, depending https://investmentsanalysis.info/ on various factors, such as stock, short interest ratio, short interest percentage, and catalyst strength, among others. After the stock reaches its peak, the stock usually plummets abruptly as short sellers cover their open positions and demand dries up. Stocks that experienced price hikes and short squeezes without the corresponding increase in fundamentals tend to recede to their pre-squeeze levels quickly.

What causes a short squeeze?

By 2006, Porsche had announced that it wanted to boost its shareholdings of VW and did so by acquiring substantially more stock in the company, which, in turn, began pushing the share price higher. As the price continued to rise throughout 2007, many hedge funds held the view that VW stock had become overvalued and increased their short positions in the troubled carmaker, which had amassed substantial debt by that time. And as the global financial crisis unfolded, of course, VW only suffered further as the demand for new cars collapsed. This made VW an even more enticing candidate for short selling, as its stock was widely expected to plummet. By measuring the coefficient of variation in Volkswagen stock prices between the seven exchanges in 15-minute intervals, I find that abnormal trading conditions can be detected by 10 am on the day before the price spike. Those with short positions may be able to exit while the Volkswagen was trading at €350, perhaps saving them from being closed out the next day as the price headed towards €1000.

Porsche pretty desperately needed money at this time, so this move was more valuable than you know! On the flip side of this action, the hedge funds who had been playing the Volkswagen short game saw losses that exceeded $30 billion. The following sections review the conditions for the Volkswagen short squeeze, examine warnings from news and technical analysis, then develop a quantitative measure of price variation which can identify the onset of the squeeze empirically.

What Was The Volkswagen Short Squeeze of 2008?

For example, you “borrow” or sell short 100 shares of GameStop for $400. Sure enough, the share price tanks, and you repurchase them back at the bargain-basement price of $40. At this point, you return your rented shares to your broker and bank $36,000 in profits. When you short a stock, you don’t own the shares outright but borrow them from your broker. I liken it to renting something; you get to use it temporarily but need to return it eventually.

Larger orders will push a stock higher much faster when fewer shares can be traded. The short squeeze started on 26th October 2008, after Porsche announced that it had increased its stake in Volkswagen. Soon, the news broke out that with Porsche’s increased stake in Volkswagen, only 6% of the Volkswagen shares were available for trading compared with the requirement of around 12% shares for covering outstanding short positions. But by driving up the price instead, the Reddit traders inflicted a “short squeeze” on the hedge funds, whereby they would have to purchase the stock at a much higher price and thus incur billions of dollars of losses.

The Epic Volkswagen Short Squeeze Explained

The stock began to appear massively overvalued, and hedge funds took notice and began shorting the stock, betting that it would go down eventually. Indeed, for those who had shorted the stock, this was a nightmare scenario. A successful short sell required them to borrow shares, sell them in the open market, hopefully buy them back at a lower price and return them to the initial lender, thus locking in a profit on the price drop in the process. But with around 12 percent of VW’s outstanding shares sold short, it was impossible for every short seller to buy back their required shares and close out their positions. As such, a massive imbalance between supply and demand for VW stock emerged.

If you miss the right time for entry, you can potentially lose money as a short squeeze can quickly peak and recede as fast as it went up. So, a wrong entry could incur losses if you do not follow the potential catalysts that drive the stock. Only a few times in history has a stock rocketed that quickly and violently to jaw-dropping prices. In this article, we’ll discuss what happened, explain what a short squeeze is, and how to search for potential short squeezes in the future.

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On 28 October 2008 a short squeeze on Volkswagen stock propelled this car maker to become the world’s most valuable company for a day. I study the market behavior empirically and investigate whether the timing of the price spike could have been anticipated from earlier trading. I utilize price information from regional stock exchanges in parallel with the primary electronic trading platform Xetra. I find that the coefficient of variation in the prices at the regional exchanges is a leading indicator of the Volkswagen price spike. That said, the following day saw Porsche unload around 5 percent of its VW holdings to the suffering short sellers.

• Panic among short sellers set in, and the supply-demand imbalance triggered a monumental short squeeze that drove its share price up from €210.85 to more than €1,000 in less than two days.
• Given this environment, it was unlikely that VW’s ordinary shares would be staying at an overvalued level, with no fundamental data supporting these prices.
• In 2008, short sellers were squeezed after market participants found that the majority of the stock’s free float was in the hands of two investors – Porsche and the German government.
• Speculators could profit by purchasing out-of-the-money call options, which means paying a relatively low premium for a chance of a much larger payoff.

After VW’s share-price peak on the 28th, its stock plunged by 58 percent in just four days as the short squeeze loosened to some degree; a month later, it was down by 70 percent from its peak. But it did not prevent painful losses from being incurred by those short sellers who ended up having to close out their positions at stratospheric price levels. This buying may proceed automatically, for example if the short sellers had previously placed stop-loss orders with their brokers to prepare for this possibility. Alternatively, short sellers simply deciding to cut their losses and get out (rather than lacking collateral funds to meet their margin) can cause a squeeze.

Did you know you can make money when a stock is falling in price? Perhaps whispers about poor earnings or bankrupts are whirling, or maybe it’s an airline company that can’t fly due to a pandemic. All of these reasons could be justification for going “short” on a stock. Short sellers need superior information in Ether trader order to overcome the additional costs of borrowing the shares to short. There is evidence that short sellers are not always right (Clunie, 2010) and not especially well informed (Best et al., 2008) besides sniffing out insurance losses (Blau et al., 2008) and accounting downgrades (Christophe et al., 2004).

We show that such an environment does not effectively prevent market-distorting events, such as short squeezes, from happening. In fact, history repeats itself as just demonstrated by the collapse of Wirecard AG. The fact that they have not been enforced in the EU’s most important country economically, namely Germany, suggests that it is necessary to implement significant changes.

The Biggest Short Squeeze In History: Volkswagen Short Squeeze of 2008

To top it off, Porsche dropped this bombshell on a Sunday, when the markets were closed. It triggered a mass panic for exits by anyone who was short shares of Volkswagen. “This is a gray area, and U.S. regulators are in the process of establishing the extent to which the coordination was in accordance with stock market regulations,” he said. “More importantly, they need strict enforcement of securities laws. As a recent example, we have the Wirecard AG scandal, which has the potential to turn out to be the biggest accounting fraud and corporate governance scandal in Europe,” he said. “This is a gray area, and U.S. regulators are in the process of establishing the extent to which the coordination was in accordance with stock market regulations,” he said. “More importantly, they need strict enforcement of securities laws.