While joining a stock market index does not impact a company’s business, it sure can create some volatility. Velodyne Lidar (NASDAQ: VLDR) announced today that it will be joining the Russell 2000 Index as part of the index operator’s annual reconstitution of the market barometers that it maintains and licenses.

The Russell 2000 is one of the most widely-followed indexes for small-cap stocks. The change will be effective on June 28.

As of 1 p.m. EDT, Velodyne shares had surged by 22%.

Why stocks jump on index inclusion

Generally speaking, news of prominent index inclusions will drive a stock’s price higher for a couple of reasons. For starters, the announcement can be seen as validation and credibility for the company that is joining an index, as the addition suggests that the stock is important enough to financial markets. 

More practically, getting added to a prominent index forces a broad variety of passive investment funds that track the underlying index to buy the shares for their portfolio. Those funds are obligated to invest in whatever is in the index. The more prominent the index, the more pronounced the effect. 

For example, the iShares Russell 2000 ETF (NYSE: IWM) is a massive fund with over $68 billion in net assets under management (AUM). That’s just one fund that tracks the popular small-cap index.

“As the first public pure-play lidar company, our inclusion in the Russell 2000 Index provides another clear demonstration of our global leadership position,” Velodyne CEO Anand Gopalan said in a statement. “We are incredibly proud of what we are achieving as a business, building game-changing products that our customers use to disrupt markets and touch everyday lives in meaningful ways.”

Triggering a short squeeze

It’s worth noting that there are other factors likely amplifying the rally. Velodyne went public last summer by merging with a special purpose acquisition company (SPAC), and investor sentiment towards SPACs has soured in recent months over valuation concerns, the excessive use of lofty forecasts, and regulatory scrutiny.

Furthermore, Velodyne has been embroiled in scandal after ousting founder David Hall and his wife Marta Hall (who served as chief marketing officer) earlier this year after an internal investigation uncovered inappropriate behavior.

David Hall, who remains Velodyne’s majority shareholder, has launched an offensive attack against the company, alleging that the board of directors has “fostered an anti-stockholder culture.” Just days ago, the founder reiterated a call for Chairman of the Board Brad Culkin and CEO Anand Gopalan to step down.

All of the controversy, combined with the backdrop of SPAC pessimism, has led to a stark increase in short interest. As of mid-May, approximately 24% of Velodyne’s float was being held short by bearish investors hoping for the stock to decline. 

Retail traders, many of which congregate on Reddit’s WallStreetBets subreddit, have started to target stocks with high levels of short interest in an effort to create a short squeeze. That occurs when short sellers, who had previously borrowed and sold the stock, frantically buy back shares to close out their positions. Short squeezes can temporarily amplify upward moves, and may be playing a role in Velodyne’s pop.

In a way, a high level of short interest can be interpreted as a coiled spring. All the stock needs is a positive catalyst—such as index inclusion—to set it off.

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Evan Niu, CFA owns shares of Velodyne Lidar, Inc. The Motley Fool has no position in any of the stocks mentioned. Millennial Money is part of The Motley Fool network. Millennial Money has a disclosure policy.

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