Why stocks that investors love to bet against often go up — a lot

A company’s stock usually rises when there is good news. But some investors often bet that a stock may be too pricey and won’t live up to the hype — only to be proven wrong.

This year, the shares of some companies that many investors have been betting against — such as Tesla, Beyond Meat and Stitch Fix — have kept exploding higher after announcing positive developments.

Tesla is a perfect example. Elon Musk’s electric car company has many fans but also detractors who think it is overvalued. Tesla is up more than 640% in 2020, an astonishing gain.

Tesla naysayers have tried “shorting” the stock: an attempt to profit from a hoped-for drop in the stock price. Short sellers borrow shares from a broker, then quickly sell them with the hopes of buying them back later at a lower price before they have to return the shares.

For example, say a short seller borrows shares at $100 and immediately sells at that price. If the stock then goes down to $80, the short seller makes a $20 per share profit when they buy the shares back to return to the lender.

That’s the scenario short sellers hope for. But it can quickly become an expensive, losing bet if a stock keeps going up — as Tesla has all year thanks to strong sales of its electric cars, several quarters of sustained profitability and the news that it was being added to the S&P 500.

As Tesla keeps climbing higher, short sellers stand to lose more and more money. That’s because they have to eventually buy back the stock they borrowed at the current higher price in order to avoid bigger losses. And they may rush to do so en masse, creating a phenomenon known as a short squeeze that can drive up a stock’s price.

Fewer investors are shorting Tesla now. Only about 6% of the company’s available shares, known as the float, are being held short. That’s down from nearly 20% of the float being shorted in February. So the Tesla skeptics appear to have learned their lesson.

Bears getting burned as stocks keep rallying

But short squeezes are happening more frequently. The broader market has roared back from its Covid-19 induced lows this spring to reach new all-time highs despite worries about high valuations.

Analysts at Citi wrote in a report last week that a relatively high amount of short interest in the S&P 500 could “lead to a short squeeze” and “grind higher” which may push the index to around 3,750 to 3,800 in the near term. That’s about 2% to 3% higher than current levels.

Individual stocks are getting squeezed higher too.

Online clothing subscription company Stitch Fix just surged nearly 40% in one day last week after reporting strong earnings. More than 40% of the company’s float was being shorted as of the end of November — so the company’s results took bears by surprise. The stock is now up 150% for the year.

Beyond Meat, GameStop and Wayfair are other well-known companies with a relatively large percentage of their shares being held short. Beyond Meat has soared nearly 85% this year, GameStop has more than doubled and Wayfair has skyrocketed almost 200%, squeezing the doubters.

Software company Cloudera, which has roughly 10% of its stock being shorted, could also pop, said Ivan Feinseth, chief market strategist of Tigress Financial Intelligence, in a report last week.

Feinseth pointed out that Cloudera recently announced plans to buy back its own shares, which could squeeze the shorts and push the stock higher.

Still, betting on stocks popular with short sellers can be risky. The shorts are often right to have doubts about high-flying stocks. Look no further than Tesla’s electric truck rival Nikola.

Short sellers had been doubtful of Nikola, and with good reason. Shares of NIkola have plummeted 75% in the past six months as the company has been hit with allegations of fraud by a prominent short seller.

Former Nikola chairman Trevor Milton has since stepped down and General Motors, which had announced an ambitious partnership with Nikola earlier this year, no longer plans to manufacture the brand’s Badger electric pickup or buy an 11% stake in the company.