What is a Short Squeeze?

Market uncertainty, investor sentiment and volatility often lead to an unexpected rise in the stock price, making many investors nervous. In panic, they end up making decisions that could result in high losses and then they make moves to reduce their losses. This shift in market sentiment causes a short squeeze. 

In the stock market, you can make money in two ways: going long and short. When you go long, you purchase the stock and make money whenever the price goes up. When you sell it at a higher rate than the purchase rate, you make a profit. On the other hand, when you go short, you borrow the stock from a broker and sell it in the market. Then, you try to repurchase the same stock at a lower rate and when you do this, you make money. 

To avoid losses, short sellers tend to exit their position in a stock by buying it, which leads to a jump in the stock price. It is a common scenario in the stock market where the price rises as the purchase volume increases. Short sellers do this by exiting their position to cut the loss. 

Whenever an investor considers shorting a stock, they assume that the price will dip in the near term. But there are chances of the opposite occurring and the only way to close the position is to buy more shares of the stock, which leads to a price rise. If the stock price increases, you’ll lose money and if it continues to increase, you will have to buy the stock at a much higher price. 

In this guide, we explain what a short squeeze is and why it happens. 

What Is a Short Squeeze?

In simple terms, a short squeeze happens when the investor who has sold shares short starts to buy them as the price rises. With solid demand for the stock, its prices will go up and short sellers will cover the position to limit losses. Naturally, as the buying increases, the demand will rise and prices will go up. There is a possibility of a loss since stock prices can continue rising. If the lender issues a margin call, the short seller will have to put up more money.

Excessive short interest can mean trouble. When shares are sold short, a small price rise will lead to buying by short sellers and thus, a rise in stock price. Investors need to be aware of short selling to be able to identify potential short squeezes before it is too late. 

How Does a Short Squeeze Work?

A short squeeze starts when a stock appears to be in a downward trend. However, there are chances of a price reversal at any time (A company announcement or better-than-expected earnings report). 

Opening a short position happens when you borrow shares because you think that the stock of a company will decrease in value. After you borrow, you sell them to an investor and once the price falls, you buy them from the open market and profit by delivering them to the original owner. The difference will be your profit. As sellers close their positions, there is an increase in demand for the stock and the price rises. This attracts other investors to the stock and, to make a profit, they start buying it. 

However, there’s no guarantee of a profit and you could make a loss if you have to buy the shares at a higher price and then sell the position. This will happen when the price continues to rise instead of falling. 

A famous example of a recent short squeeze was the GameStop stock in 2021. A social media post triggered interest in the stock, which led to the meme stock craze. It was trading for less than $2 per share but slowly started gathering momentum. Soon, the stock started to trade for $4 per share. The sudden interest in the stock attracted investors, which caused the stock prices to soar. In early 2021, the stock went from $4 to $81 in a month, driven by a short squeeze. 

Why Short Squeezes Occur

A short squeeze can occur due to multiple reasons. It could be an increased demand for a stock or positive news about a company. It is a chain reaction where the short sellers buy shares to reduce losses, thus pushing the stock price higher. 

High Short Interest

A high short interest means that many shares are sold short by investors betting against the stock. It means that investors think that the stock price will fall and if the stock price starts to rise, the short seller will have to buy back shares to cut the losses. It will lead to an opposite reaction where the prices will go up. Short sellers will then have to cover their position, taking the price even higher. A short squeeze often occurs when there is high short interest.

Positive News or Events

A short squeeze can occur due to unexpected positive news about the market, company or the economy. It is often known as a “trigger event.” If the company reports strong financials or when the government announces subsidies for companies in a specific industry, it could lead to a short squeeze. This shift of investor sentiment leads to high buying activity, which takes the stock higher. The blend of positive news and short squeeze could lead to a significant spike in stock prices. 

Low Float

When there is a limited number of shares available for trading, it is known as a low float. These shares are more vulnerable to a short squeeze. If the demand for these shares rises, it leads to dramatic price changes since only a certain number of shares are available for trading. If investors start buying the stock, the limited supply will lead to a price rise. As the price rises, the short sellers could exit their positions and drive up the price. 

Risks of A Short Squeeze

A short squeeze is driven by technical factors and not fundamental factors, which increases the risk. Investors need to be clear about their long or short position and understand the impact of the same. 

Short-lived: A short squeeze is often short-lived. It is not a way of investing for the long term and investors can never know how long it will continue. While some stocks lose value in no time, there are a few that remain elevated for a few months after the squeeze. 

Potential of losing money: There are two ways investors can lose money in a short squeeze. Either you buy too high or you sell short too low. When the stock is purchased after it has soared, there is a risk of buying at the top. On the other hand, if you want to short-sell after the stock has soared, there could be the risk of the stock going higher and you may have to close the position at a loss. 

Compare the Best Online Brokers for Short Selling

Check out Benzinga’s guide for the best brokers for short selling. While short selling isn’t the best way to make money in the stock market, if you’re interested in a short squeeze, you must exercise caution to reduce the risks. To protect yourself in this position, you might want to seek the help of an experienced broker. Here are a few online brokers that can help protect your account and make investing easier. 

Not all stocks that rise after falling are in a short squeeze. Fundamentally stable companies have a lower short interest as compared to speculative stocks. A short squeeze can be exciting for investors, but it isn’t risk-free. You need to understand the market and keep in mind that the short squeeze can end anytime. If you want to try your luck at it, tread carefully. 

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