Rolls-Royce (LSE: RR) investors have suffered more losses this year than most. Being hit by the near-cessation of the aviation industry, the company has been hammered alongside BA-owner International Consolidated Airlines. But what a day it was for the Rolls-Royce share price on Monday.
The world learned that the vaccine being developed by Pfizer and BioNTech had scored a 90% success rate in trials. And buying fever hit the FTSE 100. The index ended the day up 4.7%. And then, mid-afternoon, a sudden spike sent the Rolls-Royce share price up 98% on the day. It didn’t last very long. It soon drifted back to end on a gain of 44%. That’s still good, especially as Rolls is up another 20% so far Tuesday.
Rolls-Royce share price spike
But what caused that huge but short-lived spike? Was it some over-excited investors going all in? Did traders then take profits and pull the shares down again? I expect both of those things happened. But what about short-sellers, who are open to big risks if the Rolls-Royce share price should unexpectedly rise?
According to Ortex Analytics, Rolls-Royce is one of the FTSE 100’s most heavily shorted stocks. Hedge funds made £238m profit in October short-selling Rolls, on top of £244m in September. Could that explain Monday’s weird price behaviour?
A short-seller effectively borrows shares to sell, hoping to buy them back later at a lower price and pocket the difference. When stock markets are falling, short-sellers can profit. And selling shares they don’t actually own can put more pressure on prices, boosting their potential profits further.
Disastrous market rise
But with the FTSE 100 gaining, shorting the Rolls-Royce share price can be a losing strategy. When investing £1,000 in buying shares, the maximum possible loss is pegged to that £1,000. And a maximum possible gain is limited only by how well the company might do. But shorting £1,000 of stock and, say, it suddenly rises tenfold, £10,000 has to be found to close the short position.
To reduce those potential losses, many short investors have a stop price, and they’ll close if the price exceeds it. Automated platforms often set maximum losses too. So for those that have a short, and the price moves against them (that is, it rises too far), they could be closed out.
Stuck in a short squeeze
What happens then is a case of having to buy shares to close that short at the now-elevated price. Buying pushes the price up further, and they’re caught in what’s known as a short squeeze. It can result in a spike just like we saw Monday with the Rolls-Royce share price. Was a short squeeze really the cause? It must surely be part of it.
But what should I do about the the Rolls-Royce share price now? I’d say the events of the past couple of days should have no real bearing on our decisions. I should simply decide what to do based on my long-term view of the company. And keep at the back of my mind that shorting can be a dangerous short-term gamble. I’d leave shorting to the hedge funds.
Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.