Yahoo Finance's Jared Blikre breaks down a short-seller squeeze in this week's Yahoo U.

Video Transcript

ZACK GUZMAN: Of course, it was all kicked off by the focus on the short squeeze as more and more hedge funds were betting against that company. And in this week's Yahoo U, we figured it'd be good to take another look at what exactly is a short squeeze. In this week's Yahoo U. Of course, Brian Cheung is out and we couldn't get Margot Robbie in a bathtub to cover it the way she did for "The Big Short." But we do have Yahoo Finance's Jared Blikre, not in a bathtub today.

JARED BLIKRE: Oh, thank goodness for the viewers there. Class is in session at Yahoo U. That's a famous quote by Brian Cheung there. And I want to begin the presentation with another famous quote, and this is from Supreme Court of the United States Justice Potter Stewart way back in 1964-- "I know it when I see it." And of course, he wasn't talking about financial markets.

But we all know it when we see it, and that is a short squeeze, also known as a bubble. Here's Volkswagen. This is a MAX Chart going back to the mid 90s. Guess what? Can you point this out? Can you see it right here? Of course you can. That was a short squeeze that made Volkswagen very briefly, if only for minutes, the most valuable public company in the US, topping $1 trillion in market cap.

And that was one month after Lehman Brothers failed. That was in the heat of the moment there in the financial crisis. Everything else was going down. Volkswagen was going up in a short squeeze. So exactly how does this work? What are the mechanics of it? Well, it starts with supply versus demand. You have a fixed supply of stocks and you also have demand for it.

Now, the supply of stocks is governed by the shares outstanding that are issued by a company. And what traders pay attention to, what's really the more important metric, is the float. Different measures of estimating this. But for instance, in GameStop, they have shares outstanding of $70 million. The float is estimated to be $50 million. But in reality, it can get quite a bit lower, especially as traders enter it and stock doesn't become available.

Less stock becomes available for trading. So, bottom line, you have fixed or decreasing supply plus increase in demand for the stock, that equals higher prices. And we've seen this play out with GameStop in strides, in something this week. Now, how do you invest or how do you short a stock? First you have to locate the stock in order to borrow it. Your broker is going to help you do this and they are going to charge you a fee.

Now sometimes, a stock cannot be located or the fees are so high that nobody wants to pay. This sets up the condition for a short squeeze-- these fees and the high percentage interest in the stock. Eventually, one side is going to win out. An it's going to be the long or the short-- somebody is going to run out of firepower. I think we know who it is this week so far with respect to GameStop. We have a couple of potential outcomes here.

Either the short sellers win, and we've seen this happen time and time again. Till raised a very good example in 2018. Bitcoin is also another example of 2017. And I choose Bitcoin as an example, it's kind of interesting case here. Now, remember that run-up we had into December of 2017? That was the peak. Well, the CME issued futures-- the first big liquid futures contract on Bitcoin.

So short sellers had the ability to short it. And they indeed did that. They indeed did do that, excuse me, all the way down. Now that's only one of the many reasons for the decline in Bitcoin at the time. But I said, kind of an interesting case study right there. So what's happening in this case? Well, how is GME different? This week is very instructive because we have a number of phenomenon that has propelled GameStop to record levels here.

The first is call options. So people are not only buying-- the Wall Street vendors are not only buying the actual stock, but they're buying it through call options. They have embedded leverage. In the old days, five or 10 years ago, to do this, you needed a margin account which required $50,000 minimum. Nowadays, you can do it for $1,000, a few thousand dollars. And many of these new accounts that Robinhood is signing up right now come with that as the default.

So there's margin and leverage built into the system now. We also have this week, we've learned from Robinhood over the last 24 hours, that they had to tap a credit line. And that's because their capital position was in danger because all the gains that were made in the brokerage accounts from these Wall Street betters had to become a liability to the company. This gets to T + 2 settlement. And I'm not going to go too much in the weeds here. We've heard this phrase over the last 24-48 hours bandied about.

But essentially, if you buy a stock and you make $50 on it, at the end of the day, your brokerage account statement is going to say you made $50. But you don't actually have that stock yet because your broker doesn't have the stock. They owe it to you. And so if the stock price goes up too much and the broker doesn't have the stock, they can, in fact, get a margin call themselves. And this is what we saw. With respect to Robinhood, they had to tap Citadel for that. Citadel essentially said, you're going to have to post more money on all these trades, otherwise we're going to have to start liquidating and that would present a very uncomfortable situation.

Bottom line is dealers have to hedge too. So all of this is kind of a perfect storm, creating a unique learning situation for everybody, including me. I'm learning things along the way too as well. But in this perfect storm, what's the net result? We have a situation where we get something that looks like this. And let's go back to the Wi-Fi interactive here so we can see the weekly gains and a few losses here in some of the big names. And just some real standouts here.

We have KOSS up 2,700% in the upper left, followed by Blockbuster up 17%, GameStop 416%. What a run here. And it is instructive that today is Friday. And we have weekly options expiration. And as many as 5 million shares may have to be assigned to call option buyers by the end of the day. And if that happens, we could run into another situation on Monday.

After that settlement, where we get a potential fail to deliver on a number of those contracts, creating more demand for the stock, which continues the run-up into next week. Or something completely different could happen because, guess what, this market is one that is suffering from butterfly effect. We're seeing market of irregularities getting priced out. But I hope we all learned something today. Bottom line, it's been an incredible run and learning experience for all of us here.