Cramer: Short Selling Doomed Netflix

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NEW YORK ( RealMoney) -- How can Netflix ( NFLX) fall and fall and fall some more over the same sagging data? How can the company be worth a small fraction of what it was just a few months ago?

The answer lies in short sellers and the flawed process of betting against stocks.
Cramer: You want to know why Netflix had such a spectacular rise and fall? Blame management, but also blame the short sellers.

When you buy a stock, it's pretty simple. You place an order, a seller is found, you get your report. Usually there are so many sellers at once that unless the stock is incredibly thinly traded, say a couple of thousand shares a day, an order of any magnitude is pretty much handled in line.

But a short seller has a different set of rules. If you want to sell something you have to own or borrow it first so the buyer gets delivery of the stock. When you own it, of course, you sell it and the buyer gets the shares. But if you sell it without owning it, what does the buyer get? Does he get a notice saying "sorry stock unavailable?"

No, the buyer won't tolerate that. So the short seller has to borrow the shares, typically from what is known as the broker's electronic vault. Only after the shares have been located can the short seller go to work betting against the stock.

Now there were always deep suspicions about how long Netflix could grow. How many people want to get DVDs in the mail? How large is that audience? Aren't there plenty of alternatives, whether it be Blockbuster, or Coinstar ( CSTR) or video on demand from your cable operator?

But the company, during the days when the distributors of films and television programs were hurting, managed to lock up a tremendous breadth of product that made Netflix a joy to be a part of.

When people thought that the DVD market was getting saturated, Netflix introduced a streaming service that was wildly popular and answered the critics' worries about the next leg of growth after DVDs.

As this company grew subscribers, the number of people who thought this Netflix business would hit a wall increased almost by the day. The critics felt that either subscriber growth would peak or the cost of content would skyrocket as studios recognized that while they needed the money Netflix offered, they could play hard-to-get now that times had improved. So, they sought to short it with reckless abandon.

But the supply of stock outstanding that's needed to locate shares to sell short wasn't expanding at all. In fact, it was contracting because of Netflix's buyback.

So, shorts kept shorting and trying to borrow stock and they couldn't locate it.

When you can't locate stock you are forced to cover or buy back shares. When you saw the stock skyrocket from $50 to nearly $300, some of that demand was from natural buyers. But much more was from buyers who were forced to cover. In an amazing confluence, just at the height of when shorts were being forced to cover like mad, Netflix committed its now legendary screw up.

The longs panicked, but more importantly the shorts who would normally cushion the blow with their buying had been wiped out by the rise. The result? No floor. None. Without growth, with a shrinking subscriber base and with no natural covering short sellers what happens?

You got this astounding collapse from a level that it should never have been. You want to know why Netflix soared? Blame the short selling process. You want to know why it collapsed? Blame management, for certain. You want to know why it fell with such velocity? That's what happens when a stock gets squeezed up to the point that there's no one left to cover.

At the time of publication, Cramer had no position in any of the securities mentioned.

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