When learning how to invest in stocks and how stocks work, you may have come across the term short squeeze.
If you’ve ever heard about stocks skyrocketing in price overnight, there’s a good chance that a short squeeze was behind the action. But what is a short squeeze, and why does it send certain stock prices through the roof? And what exactly does a short squeeze mean?
Let’s break it down step-by-step so youll know exactly whats going on when you hear about this in the news.
Short squeezes occur when a highly shorted stock suddenly and quickly increases in price. A stock is shorted when short sellers bet on the stock going down. A short squeeze is a bullish market response. Successful short squeezes can cause short sellers to lose a lot of money.
However, this action causes the stock’s price to skyrocket. This creates what is referred to as a stock squeeze or a squeeze from the pressure of short sellers being forced to exit the position.
To understand the meaning of short squeeze further, it’s important to understand short and long positions, the roles of short sellers and buyers, and how these forces can create a bullish trend in the stock market.
Short squeeze definition: A short squeeze is a rapid rise in a stock or security price. Short sellers bet on the price of a stock decreasing, while regular buyers believe that the price of a stock will increase.
A short position is when a short seller borrows stock from a brokerage to sell only to buy it back later at a lower price for profit.
A long position is when a buyer actually purchases and owns stock with the hopes that the stock price will increase in value.
Short squeezes can happen for various reasons.
Short sellers run the risk of losing a substantial amount of money if their prediction of a stock price decrease reverses and, instead, increases.
To grasp the impact of a short squeeze, it’s essential to understand the basics of long and short positions in the stock market. These two approaches reflect different strategies and expectations about a stocks future price movement.
When trading in the stock market, the buyers prediction when purchasing a stock is that the price of that stock or security will increase, which ultimately leads to an opportunity for the buyer to profit from that stock.
Buyers can have long positions, which means they actually purchase and own the stock that they believe will increase over time and benefit their portfolio.
When short sellers invest in the stock market, they purchase stock with the prediction that the price of that stock or security will decrease, which will lead to an opportunity for the short seller to profit from the stock.
On the flip side, short sellers purchase stock with the prediction that the stock price will decrease. At that point, they will enter what is called a short or short position. This all begs the question of how short sellers profit from a decrease in a stocks price.
Let’s explain that a little further!
A short position occurs when a short seller sells a stock with the intention of buying it back later at a lower price for profit. When a short seller decides to sell the security, it’s called short selling.
Short selling is when a short seller predicts that the value of a stock will decrease. To profit, the short seller will borrow the stock from their brokerage to sell and then purchase the stock back later at a lower price. If all goes as planned, the difference between what the short seller sold the stock for and the amount that they bought it back for becomes their profit.
If the short sellers prediction is wrong, and the stocks value increases, it forces them to buy the stock back at a higher price from which it was sold and pay for the difference. In simpler terms, just remember that short selling is a way for short sellers to make a quick profit by borrowing a stock or security to sell and then buying it back to possibly profit and return the stock.
To gain a better understanding of how a short squeeze works, let’s break down the process into steps.
Example: Short sellers believe ABC stock is temporarily overpriced and will soon decrease in value. They borrow shares of ABC from a brokerage and sell them at the current market price.
Action: Lets say ABC stock is trading at $100 per share. The short sellers sell 100 shares, hoping to buy them back later at a lower price.
Example: Instead of the stock price dropping as expected, ABC stock continues to rise in value, driven by increased buyer interest because the companys performance is better than anticipated.
Action: ABC stock rises to $120 per share. Short sellers are now facing potential losses since they still owe the borrowed shares but at a higher price than they sold them for.
Example: The short sellers, seeing the price rising, now need to buy back the shares to “cover” their position and minimize further losses. This is when they switch from being “sellers” to “buyers.”
Action: To buy back 100 shares at $120 each (higher than the $100 they sold for), they are now incurring a loss of $20 per share. They need to return the borrowed shares to the brokerage.
Example: As more short sellers see the price increase, they get nervous and realize they need to act quickly to limit their losses. They start buying back their borrowed stock, which drives the price of ABC stock even higher.
Action: With more short sellers rushing to buy back shares, demand for ABC stock grows, pushing the price further. For example, the stock price rises to $140 per share.
Example: As the price rises, even more short sellers scramble to buy back the stock to cut their losses, leading to a feedback loop. This spirals into a short squeeze as the buying pressure causes the stock price to soar.
Action: The stock price of ABC reaches $160, and short sellers who waited too long are forced to buy back at these elevated prices, amplifying the price increase even further.
Example: What started as a few short sellers buying back shares turns into a rapid price increase, creating a “squeeze” where short sellers are trapped in their positions, and regular buyers are eager to profit from the stocks rise.
Action: ABC stock price could continue to soar as the short squeeze completes, creating massive losses for the short sellers and causing regular buyers to continue driving the price up.
After understanding how a short squeeze works, its helpful to see how this phenomenon has played out in the real world. Lets look at two famous examples where short squeezes led to massive financial impacts: the Volkswagen squeeze in 2008 and the GameStop squeeze in 2021.
Now that we know how to define short squeeze and understand how it works let’s look at a notable example from history. One of the biggest short squeezes that took place in history was the 2008 Volkswagen short squeeze. Before the short squeeze, Volkswagen was struggling to sustain itself and took a hit due to the Great Recession and the falling economy, especially since the auto industry as a whole endured some of the biggest challenges. Car sales decreased by almost 40%, and the auto industry’s employment rate fell by more than 45%. This forced many automobile manufacturers into bankruptcy.
The Volkswagen downfall sparked interest in short sellers to profit from the failing company, who, therefore, entered into a short position. However, on October 26, 2008, Porsche increased its stake by announcing a 74.1% ownership in shares of the Volkswagen company. As the financial crisis continued, the short interest in the Volkswagen company increased, which is the number of Volkswagen shares that had been sold short but not completed or closed out.
In addition, Porsche’s unexpected announcement and major increase in its stake ownership in Volkswagen left very few available shares for short sellers to account for. This unforeseen event not only created a supply and demand issue but caused short sellers to panic because they still needed to buy back Volkswagen stock to exit their positions. However, there was very little supply (shares to buy), which affected short sellers ability to close their positions. As a result, this created the 2008 Volkswagen short squeeze.
During that time, Volkswagen became one of the most valuable companies in the world as its share price increased to over EUR 1,005 per share or over $1,000 per share. Porsche benefited by reaping over $10 billion in profit, while short sellers lost billions of dollars over those couple of days. However, Volkswagens stock peak eventually came to an end, falling by almost 60% in a few short days.
Another more recent example of a short squeeze was the January 2021 GameStop short squeeze. GameStop, a retail gaming company, was affected by a decrease in mall foot traffic, the pandemic, and competition. Naturally, short sellers had grown interested in the stock’s decline. The short interest during this time grew to over 100%. However, a Bloomberg reporter, Brandon Kochkodin, described a bull case for the potential of GameStop and predicted a turnaround for the company in a few years.
During this time, day trading and individual investing had increased, and the news of this potential bull case had circulated. There was also heightened interest in GameStop in spaces such as WallStreetBets (a Reddit forum), which had pegged GameStop as an undervalued stock for some time. WallStreetBets was the driving force behind the increase in GameStop’s stock value. In addition, a well-known investor, such as Scion Assets Managements owner Michael Burry, announced he had a long position in the company. The co-founder of Chewy, Ryan Cohen, also disclosed that he had a huge stake in the company.
The result was not only retail investors continued investments in GameStop stock and call options, but also a major increase in GameStop stock price in a matter of days. On January 27, 2021, GameStop’s share price rose to $347.21, with a brief peak of $483 per share. This squeezed out short sellers, such as major hedge funds, causing them to lose billions of dollars. The event continued to attract more notable figures like Elon Musk and venture capitalist Chamath Palihapitiya.
As mentioned above, short sellers believe that there will be a decrease in a stock or securities price. If the short sellers prediction is correct, they will profit by pocketing the difference between the price they sold the stock for and the price they bought it back for.
However, if the short seller is incorrect, they run the risk of losing a substantial amount of money and may hurry to front the cost of the increased stock price to exit the position.
Since a short sellers buying decision for a stock increases its price, this ultimately leads to other short sellers buying to exit the position. In addition, a stock’s price increase may also encourage regular buyers to invest in the stock with the belief that the stocks value will continue to increase.
During a short squeeze, short-sellers run the risk of losing a substantial amount of money if the stock price continues to increase.
In addition, a large short interest can go either way, meaning that the stock price can still increase just as much as it can decrease. Short interest is an indicator that certain investors believe that the stock price will decline.
For those considering trading during a short squeeze, there are additional risks to keep in mind:
These factors make short squeeze trading highly unpredictable and best approached with caution. Its often wiser for newer investors to stick with strategies that align with their long-term goals rather than chasing short squeezes, which can be both volatile and risky.
There are various indicators that investors may use when predicting an upcoming short squeeze. Some of those indicators may be short interest, days to cover, or the short interest ratio, buying pressure, and the relative strength index (RSI).
As mentioned earlier, short interest is the total amount of outstanding shares that haven’t been closed by short sellers. A high short interest, such as 20% or above, can be an indicator of a short squeeze.
A high short interest means that a large number of outstanding shares have been sold short but not yet covered or closed. The higher the short interest percentage increases, the more likely a stock can be prone to a short squeeze.
The short interest ratio, also known as days to cover, is the stock’s total number of shares sold short divided by the stocks average daily trading volume equal to the total number of days to cover or close the position. The short-interest ratio shows the average number of days needed to exit a short position. While a low short-interest ratio shows a lower average of days needed to cover a position, a high short-interest ratio shows the opposite. A high short-interest ratio can be an indicator of a short squeeze.
The relative strength index (RSI) measures the extent of price changes to determine overbought or oversold conditions in the stock market.
A low RSI means that a stock is oversold and is trading at a low price, while a high RSI means that a stock is overbought and is trading at a high price. An RSI below 30 means that the stocks price will increase, which can signal a short squeeze.
Buying pressure, when it comes to stocks, can mean a multitude of things. However, a sudden pressure or increase in the number of shares bought can also lead to a short squeeze.
It’s important to note that buying pressure alone may not be a substantial indicator that a short squeeze will occur, but it may be used in support of other indicators.
Short squeezes can present benefits and risks depending on your investment projections as an investor. For buyers, short squeezes can result in substantial profit. However, short sellers are faced with hefty risks and incredible losses if their projection of a stocks performance doesn’t go as planned.
The short-selling strategy can be challenging for investors. Regardless of a stock’s performance and whether or not it performs well, the short seller will always have to return the borrowed stock to their broker. The short seller can pocket a profit from using this strategy, but the losses that can be accrued from this may outweigh the potential gains. It’s important to understand the risks with any investment strategy, but most importantly, how short and long positions in stocks can be a benefit or detriment to your investment portfolio.
Ultimately, investors or buyers who have long positions in stocks can benefit from the effects of a short squeeze and an instant rise in a stock’s price.
Although short squeezes may occur naturally in the stock market the U.S. Securities and Exchange Commission (SEC) states that abusing short sale practices is illegal. In addition, short sales used to manipulate the price of a stock are prohibited.
Naked short selling is when investors sell shares they don’t own, which is illegal and can increase selling pressure. A short squeeze happens when short sellers legally sell borrowed shares but have to buy them back as prices rise, driving the price up quickly.
While a short squeeze can happen in any stock, it’s more common in stocks with high short interest and lower trading volumes. These conditions make it easier for price spikes to occur when short sellers need to cover their positions.
A short squeeze is more about market dynamics than a company’s actual value. It doesn’t mean the stock is inherently good or bad; it simply reflects a high level of disagreement among investors. Some think the stock will fall, while others start buying heavily, triggering the squeeze.
