Most people buy a stock hoping for the price to go up, but some investors bet on it to go down by using a strategy known as short selling. This strategy can expose you to unlimited downside risk and the possibility of a short squeeze. Read on to learn more about what happens during a short squeeze.
What Is a Short Squeeze?
A short squeeze occurs when a heavily shorted stock experiences an increase in price for some unexpected reason. This situation prompts short sellers to scramble to buy the stock to cover their positions and cap their mounting losses. The surge in demand for the stock puts additional upward pressure on the stock price, which makes the losses even greater for short sellers who remain exposed.
For most people, investing in the stock market means that you buy a security with the expectation that you’ll profit financially as the stock increases in value. This concept is often called going long on a stock, or having a long position.
Shorting a stock, also known as selling short, takes the opposite approach. You borrow a stock via a brokerage firm (through a process known as margin trading) and immediately sell it to someone else. This strategy is primarily used when the price of the stock is expected to fall.
For a short seller, when the price of the stock falls, it lets the short seller buy the stock at a lower price than the price at which it was sold. The acquired stock is used to settle outstanding debt, and the short seller pockets the difference between the initial sale price and the purchase price.
Why Do Short Squeezes Happen?
When upward pressure on a stock price continues during a short squeeze, a virtuous cycle is created. Short sellers must buy additional shares of stocks to cover their short positions, and this frantic buying leads to a surge of additional frantic buying. Speculators looking to profit at the short sellers’ expense often add fuel to the fire. All of this pushes the stock price higher.
To illustrate this process, let’s say that you short a stock at $25, so it can’t go lower than $0 — meaning your maximum profit (before any brokerage fees) is $25. However, if the price of the shorted stock rises, you will lose money. The loss will increase as the price continues to rise, and this could continue indefinitely. The only way to stop the hemorrhaging is to close out the short position by buying the stock and settling your debt.
This dynamic reflects a technical imbalance between the demand for the shorted stock and its supply. Until an equilibrium point is reached, the stock price will continue to increase. The extent and velocity of the increase will depend on the size of the technical imbalance.
Regardless, no short squeeze is a mild event. Most are significant and result in rapid and astonishing price jumps. Short squeezes are usually short-lived, but even the briefest squeeze can cause huge losses for short sellers who are unable to close out their positions quickly.
How to Identify Potential Short Squeeze Setups
Short squeezes are most likely to occur with small-cap stocks that have a relatively small number of thinly traded shares outstanding. Sometimes short squeezes may even involve large-cap stocks with an expansive base of shareholders. Regardless of the market capitalization of the company involved, there are two main data points that can help you identify a potential short squeeze setup:
- Short Percentage of the Float —This is the percentage of shares available for trading that are currently in a short position (number of shares being shorted ÷ available shares outstanding). Anything above 10% is notable. Companies with more than 25% of their shares sold short are prime targets for a short squeeze.
- Short Interest — This ratio reflects the number of days of normal trading that it would take to generate enough trading volume to buy back all shares currently sold short. Opinions vary as to what constitutes a crowded trade, but most analysts believe that anything over 10 days indicates a prime target for a short squeeze.
Short Squeeze Examples
While short squeezes don’t happen very often, there have been many short squeezes throughout history. Most short squeezes begin with a pessimistic view on the viability of a company, and the likelihood of a short squeeze increases exponentially as this view is embraced by a wider audience and as investors increase their number of short positions.
However, it’s important to note that the business landscape is filled with unexpected developments and turnaround stories. For a highly shorted stock, if there is any positive news regarding the stock’s future, it can boost demand for the stock and ignite a short squeeze.
Let’s examine a few recent examples of short squeezes that have made the news and are a common topic of conversation for beginning investors.
GameStop Short Squeeze
One of the most publicized short squeezes involved GameStop, the brick-and-mortar retailer of video games and consoles. The short squeeze event occurred in 2021, but the lead up to it started in early 2020. At that time, GameStop hadn’t made a profit in two years, and the company had been on a steady downward decline for most of the previous decade.
During the lead up to the short squeeze, many of GameStop’s customers were choosing to buy and download their video games and equipment online instead of going into stores. Then the COVID-19 pandemic hit, and in-store foot traffic collapsed. By the end of March 2020, GameStop’s stock was trading below $4 per share (about 75% less than a decade prior).
The short sale trading began, and short positions in GameStop steadily accumulated.
By the end of the 2020, the heavily shorted stock caught the attention of an aggressive group of day traders from the /r/wallstreetbets community on the social platform Reddit. The online community realized that if they collectively and heavily bought GameStop stock, they could deal a huge blow to the hedge funds who were shorting the stock, and they could earn a profit along the way. For many of these investors, a profit wasn’t even their main goal — merely “sticking it to the man” would be enough.
The Reddit community pursued the strategy and induced a massive short squeeze, sending GameStop’s closing stock price to nearly $148 on January 26, 2021, and causing billions of dollars of losses for a few major hedge funds. An enthusiastic tweet from Elon Musk cheered on the squeeze, and the next day, a wave of new retail investors jumped into the trade, buying more stock and call options. The heightened demand drove out more short sellers and pushed GameStop’s stock to an all-time intraday high of $483.
Since then, the stock has pulled back significantly and is trading (quite volatilely) around $130. While this price is still way above its early 2020 value, it has nothing to do with the short squeeze. The elevated price is largely due to a bullish, albeit unproven, case for improved prospects and near-term profitability.
Volkswagen Short Squeeze
One of the biggest short squeezes in history involved Volkswagen. It occurred in 2008, when the European automaker became the most valuable company in the world — for a fleeting moment. As outlined below, a number of factors contributed to the short squeeze.
For starters, most of Volkswagen’s stock was held by Porsche SE and the German government, which left a relatively small number of shares trading in the open market. Additionally, there was widespread speculation that Porsche SE would make a move to buy out the other shareholders, which put significant upward pressure on Volkswagen’s stock price.
In October 2008, as the Great Recession took a toll on economic markets, the prospects of the Porsche SE deal began to fade. Simultaneously, investors hoping to capitalize on an imminent price decline took a large number of short positions. Porsche SE then shocked the market by announcing the company had been quietly building its stake in Volkswagen via call options, and that only about 6% of the stock remained in the open market.
This caused panic among the short sellers, who now realized that a very limited number of shares were available to close out their positions. The short sellers created a massive spike in demand for the stock, and over the span of a few days, the price of the stock soared more than 300%.
How to Avoid a Short Squeeze
The surest way to avoid getting caught up in a short squeeze is to refrain from short selling entirely. Nevertheless, if the lure of short selling is too compelling, there are some things you can do to minimize the possibility of being short squeezed.
- Stay away from highly shorted stocks. Short squeezes occur when the trade becomes crowded. You should always avoid shorting stocks that reflect elevated “short percentage of the float” and “short interest” ratios.
- Keep your position sizes modest. While every short sale is exposed to unlimited downside potential, it is much easier to cover small positions than it is to cover large ones. Remember, a short squeeze happens when there are more buyers than sellers in the market. You don’t want to be a huge buyer with no sellers in sight.
- If a trade moves against you, cut your losses early. Add some rigor to the process by setting a firm level at which you’ll close out the short. Perhaps it’s 7% of the shorted stock value. Under this framework, if a $100 short increases to $107, you’d close out the position immediately. Ideally, this close out would happen via an automated stop-loss order established with your broker.
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