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I am, at heart, a believer in markets. They have their limitations for sure, but most of the time they arrive at a price for a stock, commodity or whatever that reflects its fundamental value.

There are times, however, when all markets break down. The best example of that for a long time is in the recent price action for DryShips (DRYS), although in this case the market disruption can be traced to a series of decisions with unintended consequences.

The charts below represents the last year of trading in DRYS at the top, and the last ten days below. As you can see the stock had dropped from above $1000 a share in May to around $4, a decline based on what was perceived as the distinct possibility of a bankruptcy filing.

Then, following the release of an earnings report or the third quarter of this year that showed a loss of $7.70 per $4ish share things started to get interesting. Over the next four days the stock jumped 2500 percent, reaching a high yesterday of over $100 before dropping back to close at $73.00.

In this morning’s pre-market trading, however, that retracement has abruptly ended and DRYS is, at the time of writing trading at around $120.

To give some background, the move started on a couple of logical, positive notes for the company. They were in serious trouble, having been unable to repay debt instruments that became due recently and suspended payment on others, so bankruptcy definitely looked on the cards. Then two things changed. First, the company announced that it was in talks with its creditors and a small glimmer of light appeared at the end of the tunnel.

That glimmer then gained strength significantly as, after the U.S. election, the prospects for the global shipping industry began to improve. The Baltic Dry Index, the benchmark measure of shipping rates around the world was already recovering but increased the pace of gain and climbed to over 1000 for the first time in over five months. The prospect of higher shipping rates that that implies means that there has to be a decent chance that a deal will be reached. DRYS’s creditors have a much better chance of getting paid now than they did just a month or so ago.

That is what probably sparked the initial rally in the stock, and that is the market operating normally as a forward discounting mechanism as the risk of bankruptcy diminished.

What followed, though, was caused by something other than the prospects for the company.

To understand it you have to understand two things: what a reverse split is and its effects, and what a short squeeze is all about.

A stock split is when a company offers shareholders a number of shares in return for each one held. It is usually done when the price of a stock gets high enough to discourage small investors. When Apple (AAPL) was approaching $700 a couple of years ago for example, they announced a 7:1 split. For every one share of AAPL held previously holders now owned seven, but each share was worth one seventh of the price. The value of the holding stayed the same, but the stock price went from around $700 to a more manageable $100 overnight.

A reverse split is the opposite of that. The company issues one share per designated number of shares previously held. This has the effect of boosting the price of each share which can be useful, as some funds are prohibited from owning stock that trades below a certain level. That is the desired effect, but obviously issuing one share for every 10 or whatever currently in circulation has another effect. It reduces the actual number of shares that are out there.

DRYS announced a couple of reverse splits recently as the stock plummeted; 1:4 in August and then 1:15 two weeks ago. This had the effect of reducing the number of shares by a factor of 60. That made it fairly easy for traders to put pressure on those that had sold DRYS short in anticipation of a bankruptcy, and what we have seen this week is, in effect, one of the most spectacular short squeezes of all time. Once the move up began short sellers have been scrambling to cover their positions, pushing the price up with every trade.

The 2500 percent jump in DRYS then started as a move based on a more favorable fundamental outlook but has morphed into a distortion of the market by traders who saw a unique opportunity. As for what you should do about it, if you are a stockholder you might consider talking a profit soon, but if not, it is a situation best left alone until the dust has settled.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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