There is a short squeeze going on in beaten-down stocks across the cryptocurrency sector. All it takes is a quick look at the likes of Coinbase Global and Silvergate Capital to see that ' GameStop-style' dynamics are at work.
Crypto broker Coinbase spiked 24% on Thursday, bringing its gains across the past five days to 54% and its year-to-date rise above 140%. Crypto banker Silvergate (SI) jumped 29% on Thursday and is up 60% since the end of last week. Other stocks exposed to digital assets, such as Bitcoin miner Riot Platforms $(RIOT)$ and MicroStrategy $(MSTR.AU)$ -- a software group with huge crypto holdings -- show similar price action.
While these stocks have all fallen in the Friday premarket, the dynamics that caused the eye-popping moves remain intact.
Sure, the stock market is on a roll. The S&P 500 has marched more than 3% higher since last Friday, with the Nasdaq -- filled with high-growth stocks like those in crypto -- climbing 6.4%. But the largest digital asset, Bitcoin, which has a lot of influence on sentiment for crypto stocks, is little changed across the same period.
What investors are seeing is likely a short squeeze -- a technical market factor that was behind the incredible rallies in "meme" stocks popular among retail traders in 2021, including GameStop $(GME)$, AMC, and Bed Bath & Beyond $(BBBY)$. It has to do with betting against stocks.
In order to bet against -- or "short" -- a stock, investors have to borrow the underlying shares and then sell them, wagering that they can be repurchased at a lower price. The trade involves pocketing the difference between the price at which the shares were borrowed and the price at which they were returned.
If the bet goes wrong and the price rises, investors can come under pressure and some may opt to repurchase and return the shares at a higher price, "covering" their position and taking a loss. Pressure can be particularly pronounced if the trade was made with margin, or money borrowed from a broker. If shorting is a crowded trade, then investors can end up clamoring to buy up the same shares, "squeezing" prices higher.
Shorting crypto stocks is a very, very crowded trade. And that's understandable. Crypto prices have collapsed since their November 2021 high, with a spate of bankruptcies and high-profile fraud allegations rocking the digital asset industry, raising the prospect of existential threats from regulation and wary investors.
But now what once seemed like a smart trade looks dangerous. Short squeezes can be unpredictable, and investors would be right to exhibit caution. The extent of the short-squeeze risk is remarkable.
Among U.S. stocks, the average short interest -- the percentage of a company's shares sold short -- is 4.9%, according to financial data group S3 Partners. Coinbase has short interest of more than 25%. An astonishing 75% of Silvergate shares are being shorted. Short interest at both Riot and MicroStrategy is in the double digits.
As these stocks get squeezed, the pain for short sellers is ratcheting up. Those betting against Coinbase, Silvergate, Riot, and MicroStrategy lost more than $730 million on a mark-to-market basis in Thursday trading alone, according to S3. Mark-to-market losses for traders shorting these four stocks exceeds $2.5 billion in 2023.
"Because of these mark-to-market losses these stocks are highly squeezable," said Ihor Dusaniwsky, a managing director at S3. "I'm looking for the short squeeze in these stocks to push stock prices higher."
And there is reason to believe the ride will only get bumpier. Short-sellers have yet to meaningfully cover their positions, meaning that the squeeze has the potential to be accelerated -- sending prices even higher -- if the pain becomes too much.
"Surprisingly, even with these stocks rallying, we have not seen massive short-covering yet," Dusaniwsky said. "But we expect this to change as large mark-to-market losses in 2023 will start to squeeze shorts out of their positions."
But, on the other hand, this doesn't mean that going long on Coinbase or Silvergate is a good idea. Short squeezes can peter out -- and flip -- just as fast as they started. These stocks have gained because of unpredictable technical, not fundamental, factors. The same can be true in reverse.
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