Stock Market

What Is a Short Squeeze in Stocks?

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.

Short squeeze, explained

To understand the short squeeze meaning further, its 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.

What is a long position?

When trading in the stock market, the buyer’s 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.

What is a short position?

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 questionhow do short sellers profit from a decrease in a stock’s price? Lets 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, its 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 seller’s prediction is wrong, and the stock’s 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.

How does a short squeeze work?

To gain a better understanding of how a short squeeze works, lets break down the process into two phases. The first phase of short selling is to sell the stock, and the second phase (which is mandatory) is to buy the borrowed stock back to return the stock to its original owner.

For example, lets say ABC stock has been creating a buzz in the stock market, causing buyers to invest in the stock because of its good performance and their prediction that it will continue to increase. On the contrary, it has also sparked interest in short sellers, who are predicting that ABCs stock value will eventually decrease, and its only on a temporary upward trend.

To enter into this trade, short sellers will borrow ABC stock from their brokerage to sell the stock first, and, if everything goes as planned and ABCs stock price decreases, they will purchase ABC stock back later at a lower price and make money.

When short sellers enter into the second phase to purchase ABC stock back, this makes them buyers. Therefore, if buyers are purchasing ABC stock and short sellers (who turn into buyers in the second phase) are buying back ABC stock, the share price of ABC stock will continue to increase. The result of this will not only cause ABCs share price to increase, but it will also cause other short sellers to get nervous that ABCs stock is continuously increasing instead of decreasing. This will lead to more short sellers rushing to buy ABC stock back to exit their position and minimize further loss. It will also cause regular buyers to continue to purchase ABC stock because of its continued increase in value. This phenomenon creates a constant spiral effect of buyers purchasing ABC stock because of its good performance and short sellers purchasing ABC stock to exit the position and cut their losses. The result in this example is a short squeeze, or a rapid increase in ABC stock that causes short sellers to get squeezed out of their positions.

The Volkswagen squeeze

Now that we know how to define short squeeze and understand how it works, lets look at a notable example in 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 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 industrys 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, Porsches 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, Volkswagen’s stock peak eventually came to an end, falling by almost 60% in a few short days.

The GameStop squeeze

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 stocks 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 GameStops 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 GameStops stock price in a matter of days. On January 27, 2021, GameStops 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.

What triggers a short squeeze?

Short squeezes can happen for various reasons. Some events that may encourage short sellers to open positions can include a product announcement, a positive news story, or an increase in the stock’s performance that attracts buyers.

What happens after a short squeeze?

As mentioned above, short sellers believe that there will be a decrease in a stocks or securitys price. If the short seller’s 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 seller’s buying decision for a stock makes a stock’s price increase, this ultimately leads to other short sellers buying to exit the position. In addition, a stocks price increase may also encourage regular buyers to invest in the stock with the belief that the stock’s value will continue to increase.

Risks of short squeeze trading

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.

Spotting short squeeze stocks

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).

Short interest

As mentioned earlier, short interest is the total amount of outstanding shares that havent 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.

Short interest ratio or days to cover

The short interest ratio, also known as days to cover, is the stocks total number of shares sold short divided by the stock’s 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.

Relative strength index (RSI)

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 stock’s price will increase, which can signal a short squeeze.

Buying pressure

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. Its 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.

More stock squeeze FAQs

Who benefits from a short squeeze?

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.

Are short squeezes illegal?

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.

The bottom line

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 stock’s performance doesnt go as planned.

The short selling strategy can be challenging for investors. Regardless of a stocks 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. Its 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.

However you choose to build generational wealth, the proper research can steer you in the right direction. Download the Public app today to learn more ways to invest and save for retirement.

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