Short Squeeze
Refers to when a shorted stock's price rises and sellers choose to exit their position to avoid even more significant losses.
What is a Short Squeeze?
A short squeeze is when a shorted stock's price rises, and sellers choose to exit their position to avoid even more significant losses.
The securities must have an extraordinary number of short sellers holding positions in them for a squeeze to happen. It is an unusual circumstance that causes the price of a security to rise quickly.
Short sellers may need to act quickly to reduce their losses when the price of a security that has been substantially shorted unexpectedly rises.
Short sellers borrow shares of an asset they believe will drop in price to buy them after they fall.
If their predictions are correct, they buy back the shares at a lower price and keep the difference in price between when they started the short position and when they closed it. They will be forced to complete the work at a loss if their predictions are wrong.
When short sellers exit their positions, they open buy orders, which pushes prices higher. This rapid price rise attracts new buyers, creating a snowball effect and an astronomical price rise.
Key Takeaways
- A short squeeze is a rare market phenomenon that is bad news for short sellers and good news for investors going long.
- The Squeeze happens when a stock with a high short interest rises in price, causing short sellers to close their positions ( buy back shares) which also entices long investors to pile up on the stock.
- These squeezes are extremely difficult to predict. However, with the right resources, you can identify highly short stocks.
Why Short Squeezes Happen
As noted, sellers short stocks that they believe will decline in price. However, not everything always goes according to plan. Here is what may happen when a short squeeze occurs
1. You decide to go short on an overpriced stock
You identify security that you think will drop in price in the future. You borrow the shares and sell them at today's price, anticipating the price will go down in the future, and you will be able to repurchase them at a lower price.
2. However, your plan isn't working out, and the stock price rises
There can be many factors affecting the stock price of a security. These events include earning reports, news announcements, or other investors heavily buying or selling the stake.
3. You decide to exit the position and cut your losses
Since the stock price is rising, you must now either borrow more shares, which will increase your risk, or exit your position at a loss, meaning you are buying back the shares you borrowed at a higher price than you hoped.
4. All the short sellers closing their positions will cause the stock price to rise even more
The increase in stock prices also entices new buyers, causing the security price to rise, even more, snowballing into what we call a short squeeze.
Did you know?
A highly shorted security means that investors are betting the stock price to go down. However, an unusually highly shorted stock could also represent an opportunity for a short squeeze.
predicting a short squeeze
Since such squeezes often happen quickly, very experienced traders often cannot predict them. However, once you understand the often-precedent indicators, you may be able to predict a squeeze before it happens.
1. High Short Interest
If a high proportion of your stock is sold short, that could suggest a squeeze. However, a high short interest simply means that investors are betting the stock price will fall.
2. Increasing Borrowing Costs
Short sellers have to pay interest on the shares they borrow. If that interest rate were to increase suddenly, it could indicate that short sellers would start to exit their positions, which may cause a quick squeeze.
3. News Announcements
Sharp stock price rises are often caused by a company announcing positive news; earning calls, product announcements, or even positive guidance can quickly increase the stock price.
Example of a Short Squeeze
There have been many squeezes; however, the most recent prominent example of a temporary reduction occurred in January 2021 with Gamestop (GME). As soon as the GME squeeze started to appear, many other securities with a high short interest followed suit.
The short squeeze in GME gained popularity online and spiked the interest of hedge funds and retail traders. It started as a Reddit discussion and became one of the stock market's most notorious phenomena.
Due to the rise in competition, decreasing revenues, and the pandemic forcing Gamestop stores to shut down, GME became a target for short sellers to attack.
The short sellers have been betting that the stock price will go down for years, and some were betting that the company would go bankrupt.
The Short Interest, at one point, had risen to over 100% of all outstanding shares. This means that there were more shares shorted than shares outstanding. Around that time, some investors thought that Gamestop could turn a profit in the coming years.
These arguments started getting attention on Reddit, and large investors such as Michael Burry and Ryan Cohen began to go long on GME.
The snowball effect of investors buying shares and call options on GME caused the short sellers to close their positions, which in turn caused the stock price to rise further and enticed other buyers to jump on board.
As a result, Gamestop's stock price surged from less than $5 a share to $325 a share in less than six months.
Where Can I Find Stocks that are Highly Shorted?
"The possibility of a short squeeze is one reason some analysts consider a high amount of short interest a bullish indicator. Short interest is the fuel, performance is the fuse", says ShortSqueeze.com.
Financial portals like Yahoo Finance offer free stock screeners that present a list of equities with high short interest. In addition, these screeners show data on specific stocks, like the number of shares sold short and the short interest ratio.
The Wall Street Journal also provides short-selling data on any public company tracked on the "Market Data" page. To access this page, search for the stock's ticker symbol and find the heading "Shares Sold Short."
Exchanges like the New York Stock Exchange and Nasdaq also release information on overall short interest.
Risks associated with trading short squeezes
To profit from the possibility of a short squeeze, many investors may purchase shares of companies with high short interest, expecting the stock to squeeze. However, while a sharp increase in stock price can be rewarding, risks are involved.
Typically, heavily shorted stocks are heavily shorted for a reason. For example, it may be because the company is losing money, its revenues are decreasing, or the company is in a dying industry.
Active traders will keep an eye on heavily shorted companies and wait for them to start climbing. This rise in stock price may signal traders that some of the short sellers are starting to close their positions, meaning it may be time for a reversal.
The trader enters the market to purchase when the price begins to gain momentum to profit from what might be a short squeeze in the making and a significant move higher.
There are tons of examples of stocks that rapidly increased in price after they had high short interest. However, there are also many examples of heavily shorted stocks that have never recovered.
A common misunderstanding is that any stock with high short interest will rise. On the contrary, a high short interest only means that investors are betting that the stock price will fall.
Anyone who buys into heavily shorted stocks should have a justification for why they think a short squeeze will happen.
Biggest Short Squeeze in History
Volkswagen experienced such a squeeze during the 2008 global financial crisis and quickly surpassed all other companies worldwide.
Volkswagen became a target of short sellers in 2008, as most of the world struggled to recover from the Great Recession due to its heavy debt burden and exposure to the business and credit cycles. The Volkswagen squeeze was a result of a variety of circumstances.
Porsche and Volkswagen
Porsche SE, a holding company, controlled many Volkswagen shares. As a result, very few shares could be traded on the Frankfurt stock markets because Porsche held most of the shares.
Speculation about Porsche wanting to increase its share in Volkswagen first surfaced, prompting many traders to buy the stock.
Porsche verified the rumors, stating that in addition to its existing 44% interest in Volkswagen, it has also added a 31% holding through cash-settled call options.
Since the German state of Lower Saxony owned the remaining 20% of the stock, fewer than 6% of Volkswagen shares were available for trading on the market.
Many hedge funds and short-sellers banking on a lower price for Volkswagen stock were taken off guard by the revelation.
Since the hedge funds had borrowed 13% of the Volkswagen shares and had shorted them, Porsche had the upper hand. With only less than 6% of the shares available, the hedge funds had to repurchase 13%.
In just two days, the stock of Volkswagen increased from €210 to more than €1,000 due to their mad rush for the few remaining shares.
The intense pressure compelled short-sellers who had bet that Volkswagen would decline to purchase the shares at steadily rising prices to cover their short holdings.
As a result, Volkswagen's market value increased to $370 billion in just two days, making it the most valuable company in the world.
The Rise and the Fall of Volkswagen
Upon Porsche's statement that it would sell up to 5% of its stake, the stock fell dramatically after rising more than €1,000. Porsche blamed hedge funds and short sellers for the sharp rise in the value of Volkswagen stock.
The impact was swift as the price of Volkswagen shares fell by 37%. A few weeks later, the stock had fallen by 70% from its high.
How long can it last?
Depending on how many shares were shorted, it may last anywhere from a few days to several months. The short interest ratio, determined by dividing a company's shorted stocks by its average daily trading volume, is one method of calculating this.
This gives you a number called “days to cover” – the amount of time it may take sellers to cover their short positions, although it may take less time if the squeeze is more aggressive than first perceived.
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