A critical mistake cost traders betting against Snap huge profits

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• Snap turned in a disastrous third-quarter earnings report that saw its stock plummet as much as 22% in post-market trading.
• Short sellers pared positions in the weeks leading up to earnings, costing themselves potentially huge profits that would've resulted from the stock drop.
• Even Tencent's acquisition of a 10% stake in Snap couldn't rescue the company's shares, which are still trading down about 15% in early trading on Wednesday.

Snap may be the most shorted app-based company in the world, but traders betting on a decline in the stock just took their foot off the gas at exactly the wrong time.

They covered $115 million of their positions in the week leading up to Snap's disastrous earnings report, and trimmed $278 million from a year-to-date high reached in mid-October, according to data compiled by financial analytics firm S3 Partners.

As Snap's stock plummeted as much as 22% in post-market trading after reporting smaller-than-expected user growth and a huge drop in advertising rates, those short sellers who exited their positions missed out on a potentially huge windfall.

While Snap bears certainly reaped at least some healthy profits from the decline - after all, S3 Partners says that $1.7 billion of the company's shares are still held short - there's no denying that many will be lamenting the missed opportunity.

Their short covering was nearly rewarded in early-morning trading as Chinese investment holding company Tencent made a 10% investment in Snap, according to a CNBC report. The news temporarily erased most of the loss almost immediately, before more sellers stepped in and pushed shares back down. Snap was trading down about 15% in pre-market trading as of 8:06 a.m. ET.

The fact that short sellers pared their positions heading into earnings is fairly surprising, considering the 18% implied share move being signaled by the options market the day before, according to Bloomberg data.

While it's possible that traders figured Snap's already-damaged stock couldn't possibly fall much further, or perhaps they were just outwardly bullish on the company's earnings prospects, it's still surprising that they went so far to dent the profits that would result from a huge share drop.

Snap's stock is now down 20% since its initial public offering at $17 in March, and with the way things are going, short sellers might think twice before throwing in the towel on positions in the future.

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