A short squeeze is a market event in which short sellers quickly close out bearish positions in a stock, leading to a dramatic surge in the share price.
Short squeezes typically occur after a company stock posts a sudden increase. This causes short sellers to try to exit a bearish position quickly.
But in order to exit their short positions, these investors have to actually buy back shares they’ve lent out. This causes further gains in the share price, sometimes to dizzying levels.
Here’s a deeper dive in to how short squeezes occur and what investors should know about them.
What Causes Short Squeezes?
To understand how short squeezes occur, we first have to understand how shorting a stock works. To sell a stock short, an investor must first borrow the shares. They then consequently sell in the open market. At an agreed-upon time, the investor will buy back the shares in order to return them to the original lender.
If the stock goes down between the time they borrow the stock and when they return it the investor makes money. That’s because they pocket the difference between what they sold the stock for and what they purchased it for when it came time to return it.
There are many investors, both retail and institutional, who use short selling to bet that a given stock will go down over a fixed period of time. But short selling is incredibly risky as stock prices have historically tended to drift upward. And timing a bearish position can also be picky. Even if an investor has good reason to believe that a company’s shares will fall, it could be some time before they actually do.
And what happens if those short investors borrow a stock that goes up instead of down? They lose money.
Example of Short Selling
Let’s look at a hypothetical case of a short sale. Let’s say an investor borrows a stock that’s trading at $10 with an agreement to pay back the shares in 90 days.
The investor then sells the stock for $10. Then 90 days later, if the stock is trading at $5, they can buy back the number of shares they borrowed and return them to the lender, capturing the $5 per share profit (often minus interest and fees).
Example of Short Squeeze
Now, let’s use this example to look at a short squeeze. Let’s say the investor borrows the stock again that’s trading at $10 with an agreement to pay back the shares in 90 days.
This time however, the share price shoots up to $15. The investor still has to buy the shares they borrowed and return them to the lender. But other investors are also trying to cover their short as well, so there’s a shortage of shares in the market to buy back.
The shortage causes the stock’s price to jump even higher to $20, which in turn triggers other short sellers to close their positions. They have to now also purchase back shares, and hence a buying frenzy and short squeeze occurs.
Theoretically, there’s no limit to how much money short sellers can lose. When an investor is long a stock but wrong, the share prices can only go down as low as $0. But when an investor is short and wrong, the share prices can go infinitely higher, making it possible losses can be limitless for the short-selling investor.
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Famous Short Squeezes
One famous example of a short squeeze in 2021 was video-game retailer GameStop, which jumped 2,300% in a few weeks as a wide range of investors looked to take advantage of the high number short sellers in the stock. But GameStop is hardly the first or only example of a short squeeze.
In 2008, Volkswagen briefly became the world’s most valuable stock by market cap when it became known that Porsche was increasing its stake in its fellow German carmaker. Tesla has also experienced short squeezes due to its popularity among investors who are fans of the electric carmaker and short sellers are dubious about the company’s future.
What’s a Long Squeeze?
By contrast, a long squeeze is when short sellers drive down the price of a stock or asset until the bullish investors begin to sell their positions in response, driving the price lower still.
How to Trade a Short Squeeze
Given the chance for dramatic returns, many investors have taken an interest in getting in on the winning side of a short squeeze.
To invest in a short squeeze, traders start by surveying the markets for stocks that have garnered substantial interest from short sellers. This factor is often called “short interest,” and as a metric, it represents the number of a company’s shares that have been sold short, but not yet returned to the lender. Traders know that the short sellers of all those shares will have to buy back shares – at any price – to return them to the lender.
There are two ways to understand short interest. One is short interest percentage, which shows how many of a company’s overall shares are currently shorted. A higher number means that more short sellers will be bidding up the stock to buy it back. The second metric is short interest ratio, which shows how much short sellers are responsible for a stock’s daily trading volume. A higher ratio means it’s likely that short sellers will help drive up the stock’s price once it starts to rise.
Another key metric has to do with when the short sellers will have to deliver those shares to the lender. It’s known as “days to cover,” and it’s the ratio comparing the total short-selling interest in a stock with the average daily shares that trade. As a metric, it gives traders a sense of how long until short sellers buy back the stocks they borrowed for their short positions.
Stocks with a high short-interest number and a high days-to-cover number are vulnerable to a short squeeze. Once these traders find stocks that seem like short-squeeze candidates, they buy the stocks outright, and watch those key metrics, along with the news, to decide when to sell. Short squeezes can make a stock shoot up, but those returns often evaporate quickly.
Risks of a Short Squeeze
While short squeeze investments can produce eye-popping returns in the short term, they come with real risks. The first has to do with the stocks themselves. If they’re heavily shorted, it’s because investors have ample reason to believe that the underlying company faces significant business issues.
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Stocks with a high short-interest number may be undervalued or misunderstood, or they may simply be a failing businesses. And if there is no good news, or market interest, they may continue to sink. What spurs a short-squeeze rally? Sometimes it’s good news, like a merger, announcement, sometimes it’s dumb luck.
At the same time, the price increases caused by short squeezes are short-lived. Once the short-sellers have paid back their lenders, the market runs out of buyers who will pay any price for that stock. And the share prices often fall as quickly as they rose. The danger to traders in a short squeeze is that they’ll get in too late and stay in too long and lose money.
Long-term investors may try their hands at winning a short-squeeze trade here and there. But it requires deep research, constant monitoring and the ability to move in and out of a stock quickly.
A short squeeze is a market event in which investors inadvertently bid up the price of a heavily shorted stock, while trying to get out of their bearish positions. In order to buy the stocks that investors borrow to sell short, those investors must buy the stock at ever-increasing values.
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