Ever since the short squeeze saga from early 2021 that saw stocks like GameStop (NYSE: GME) and AMC (NYSE: AMC) skyrocket as bears scrambled to cover short positions – leading to extraordinary gains for investors on the long side of the trade – short squeeze strategies have become increasingly popular among investors and traders. As a leading provider of actionable real-time short interest data, ORTEX is grateful to count many such traders as our subscribers.
The growing awareness of short squeeze strategies has led investors to seek out exchanged traded funds (ETFs) with high levels of short interest from short sellers in an effort to similarly find additional candidates that may be susceptible to a short squeeze. However, it is important for investors to understand that many of the market mechanics that come into play when attempting to squeeze an individual stock do not apply to ETFs, significantly reducing the possibility of a short squeeze occurring in an ETF; in fact, it’s nearly impossible.
How shares outstanding differs for stocks and ETFs
One of the most important liquidity metrics that traders analyze when pursuing short squeeze strategies is free float, an estimation of the subset of shares outstanding that are freely tradable. If short interest is a large percentage of free float, there is a greater possibility of catalyzing a powerful short squeeze, as buying demand from short covering may dramatically exceed and overwhelm the supply of available shares.
In many cases when individual stocks experience a short squeeze, the magnitude of the movement is often unrelated to fundamental drivers for the company itself. Rather, the price spike is primarily driven by the market dynamics mentioned above. A fundamental event can serve as a catalyst for a short squeeze, but the sheer intensity of buying demand can create a disproportionate movement in the stock that may not necessarily be justified by future cash flows to the business.
Most importantly, a company has a relatively fixed number of shares outstanding, and therefore free float, at any given time. The number of shares outstanding does fluctuate – increasing as companies issue more stock to raise capital or compensate employees, or decreasing due to share repurchases – but these activities tend to occur slowly over time. The finite nature of free float is a critical requisite when attempting to create a short squeeze.
In contrast, an ETF does not have a finite number of shares outstanding. Instead, the total number of shares that exist for an ETF is constantly fluctuating due to a unique creation and redemption mechanism. All ETFs have Authorized Participants, which are typically large financial institutions, that play an important role in the ETF ecosystem.
Creating and redeeming ETF shares
Authorized Participants are able to create ETF shares dynamically by exchanging the underlying basket of stocks for shares of the ETF, increasing shares outstanding. Conversely, Authorized Participants can also redeem ETF shares for the underlying basket of stocks, decreasing shares outstanding. This mechanism helps keep the market price of an ETF as close as possible to the underlying net asset value (NAV) of the fund.
By playing this important role, Authorized Participants are compensated with arbitrage opportunities. If the ETF market price is too high relative to NAV (a premium), the Authorized Participant will buy the underlying stocks to create ETF shares that are subsequently sold into the market. If the ETF market price is too low relative to NAV (a discount), the Authorized Participant will redeem the ETF shares for the underlying stocks that are subsequently sold into the market. Let’s walk through a couple of hypothetical scenarios to illustrate how this process works.
If an ETF’s market price is $150 but the NAV of the underlying securities is $149, Authorized Participants will buy the basket of stocks for $149 that can be used to create new ETF shares, and then sell the new ETF shares for $150 into the market. The Authorized Participant then realizes an arbitrage profit of $1.
If an ETF’s market price is $150 but the NAV of the underlying securities is $151, Authorized Participants will buy ETF shares for $150, redeem those shares and dismantle them into the underlying basket of stocks, and then sell the stocks for $151 into the market. The Authorized Participant then realizes an arbitrage profit of $1.
The dynamic supply of shares prevents squeezes
This creation and redemption mechanism is the primary reason why it is nearly impossible to engineer a short squeeze for an ETF. While technically possible in theory, a short squeeze should not occur if Authorized Participants are properly playing their role in pursuit of arbitrage profits. Triggering a short squeeze in an ETF would require a systemic breakdown of one or more of the mechanisms that underpin ETF market structure. Such a breakdown would require rather extraordinary market conditions.
ETFs can also experience high levels of short interest, sometimes in excess of 100% of free float, for the same reason as individual stocks: Shares can be borrowed and lent multiple times throughout the securities lending cycle. However, the creation and redemption process is designed to keep the market price very close to NAV under the vast majority of market conditions.
A different strategic reason to short
Another important distinction is that shorting ETFs is a popular hedging strategy for large institutions that wish to reduce their net exposure to a sector. This is a meaningful contributor to elevated ETF short interest, which also provides additional perspective to the data. Most institutions are not shorting ETFs for bearish speculation.
Consider a large fund that has shorted an ETF for hedging purposes. As part of a multi-leg strategy, price fluctuations in the ETF are unlikely to create a sense of urgency in closing out the short position since the movements may be offset by other positions in the portfolio, thereby undermining some of the dynamics that can lead to short squeezes in individual stocks. Additionally, ETFs do not typically experience dramatic movements since they generally consist of a diversified basket of stocks.
What about demand for the underlying stocks?
This all naturally leads to another question: Can trading activity from Authorized Participants that are creating or redeeming ETF shares impact the price of the underlying stocks?
While Authorized Participants do indeed trade in the underlying stocks, this activity is fairly minimal relative to other market activity. That’s especially true since most ETFs track market indexes. Most market indexes are weighted by market cap, so the largest components of the index will also be the largest in market cap. Stocks with large market caps are very liquid and often have high daily trading volumes that can easily absorb activity from Authorized Participants.