A short squeeze can quickly move a stock price higher, often much higher. It can be an exciting event, as traders rush in to buy, pushing up a stock’s price. The stock spikes, potentially leading to even more buying as short sellers are forced to “cover” their shorts. Metaphorically, think of a short squeeze as investors rushing to get out of a crowded theater after someone yells “fire.”
Here’s how a short squeeze works, how it happens and the risks of trading during a squeeze.
What is a short squeeze?
A short squeeze occurs when a stock moves higher and short sellers decide to cover their short positions or are forced to do so via margin calls. As these short sellers buy the stock, the price rises, potentially creating a situation in which more shorts have to cover. This sends the stock soaring even further in a vicious cycle. In theory, there’s no limit to how far a stock can rise.
The backstory: In investing, there are two main ways to make money:
- Going long: When you go long, you buy stock and make money when it goes up in price. You can sell the stock or hold on and see if it goes up further. Generally, when people talk about investing, they’re talking about going long.
- Going short: When you go short, you borrow stock from your broker to sell in the market. Then you attempt to repurchase the stock at a lower price. If you do so, you’ll make money on the trade. However, if the stock rises, you’ll lose money and, if the stock rises too much, you may be forced to repurchase the stock at a much higher price.
So, when it comes to a squeeze, short sellers decide to repurchase the stock, sending it higher. Small-scale short squeezes may happen any time, for example, after a company reports earrings. The stock may rise as “longs” purchase it, and the higher price hurts short sellers, so they decide to close their position by repurchasing the stock, putting further upward pressure on the stock.
In spectacular situations, however, the stock may rise 10-50 times in value, sometimes over just a few days. These situations are sometimes called the “mother of all short squeezes” and they can be tremendously lucrative for long investors and ruinous for short sellers. One of the most famous recent examples of a short squeeze was the massive rise of GameStop stock in 2021.
How a short squeeze happens
A short squeeze can happen for a variety of reasons, but a key aspect of the process is the fact that short investors have borrowed money to go short, and therefore must buy it at some time in the future to close the position.
Key elements of a short squeeze include:
- Borrowing on margin: Short sellers owe money to their brokerage as part of the short-selling process, and if a trade goes against them, they’ll end up owing even more. If their margin loan goes too high, the broker will force them to close the position or add more equity (for example, cash) to their account to hold the short position.
- High “short interest”: Short interest is a measure of the percentage of a company’s outstanding stock that is sold short. The higher the short interest, the more volatile a stock can be, and the more shares that will have to be repurchased later to cover short positions. A stock’s short interest is typically reported every two weeks.
- High “days to cover”: Days to cover is a measure of how fast shorts could close their positions, given a stock’s daily trading volume. The higher the days to cover, the more volatile a stock during a squeeze. For example, if a stock has a short interest of 100 million shares and trades 2 million shares a day, then it would take 50 days to close the short position. In contrast, a normal stock might have days to cover of less than 10.
- A “trigger” event: Often a short squeeze needs some kind of catalyst or trigger. That trigger could be a good earnings report that forces the market to re-evaluate the firm, or it could be a rising stock price that slowly squeezes shorts until it suddenly forces many to race for the exits. The trigger ignites forces such as high short interest, high days to cover and the shorts’ borrowing into the short squeeze.
- A self-perpetuating cycle: As the stock rises during a squeeze, not all investors can close their positions at the same time, especially if days to cover is high. They may end up fighting to buy stock regardless of the price in order to close the position. Then investors who at first thought they could ride out the squeeze may be forced to buy, and as the price rises, more and more investors are inclined or are forced to close out.
While high-profile squeezes get a lot of press when they occur, many stocks experience short-lived squeezes throughout a typical year as longs and shorts battle back and forth.
Risks of trading in a short squeeze
Whether you’re going long or short during a short squeeze, your portfolio can be severely hurt during a squeeze by the following risks:
- The short squeeze may continue for a long while (or not): A short squeeze may be short-lived or long-lived, and you’ll never know until it plays out fully. While a stock may spike much higher during the most acute phase of the squeeze, some stocks can stay elevated above their fair value for years.
- Short interest is usually high for good reason: Short sellers are some of the most well-informed investors in the market, so the fact that they’re short a stock should be a gut check to investors looking to go long. If a stock has high short interest, there’s probably a good reason for it. Understand why the shorts are short.
- Potential that you buy too high: If you’re buying into a short squeeze after it’s soared, you run the risk of buying near the top or at least a local maximum.
- Potential that you short sell too low: If you’re looking to short sell a stock after it’s soared, you run the risk that the stock could run up even more and that the squeeze is not over yet. If you’re wrong here, you could quickly have to close your position at a loss.
- Timing the market: If you’re trying to trade a specific event such as a short squeeze, you’re trying to time the market and outguess other traders. In the short term, anything can happen in the stock market, meaning you could make or lose money quickly.
Because short squeezes are often driven by technical factors (short sellers covering their positions) rather than fundamental factors (strong business performance), it’s vital that long investors clearly understand the long-term prospects of the business. If short sellers are mistaken and the business is not overvalued or impaired, going long could be quite profitable.
Examples of short squeezes
Short squeezes can grab the imagination of the investing public because of the potential for quick money and the chance to participate in the Wall Street action. GameStop is one of the most high-profile short squeezes of the recent past. The trading action gripped investors (and arguably still does) as the stock remains at an elevated price long after the immediate short squeeze.
As recently as September 2020, GameStop traded for less than $2 a share (split-adjusted). It slowly gathered momentum through the end of the year and started 2021 at more than $4 per share. Many investors thought the company was going broke and invested accordingly. One short seller had a huge position in the stock, and short interest was greater than the number of shares of outstanding stock. Even relatively modest rises in the stock could stoke a squeeze.
And that’s what happened by late January 2021. The stock’s momentum built on itself, and by the end of the month the stock had soared to more than $120 intraday – up some 60 times in price from just months before. The stock came off that peak but has remained elevated since.
The stock of theater chain AMC has also been the subject of a short squeeze, though not as prominently as GameStop. Some have suggested that Tesla has been subject to a years-long short squeeze, given its high short interest and massive overvaluation, relative to competition.
A short squeeze also figures prominently in the plot of the classic film “Trading Places.” In the film the main characters “put the squeeze” on orange juice commodity futures.
Short squeezes can be exciting, especially if you own the stock before it rockets higher, though many short squeezes are relatively modest. Still, it’s important to understand that no one knows when a short squeeze will end. So, if you decide to try your luck trading them, tread carefully.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.