What is a Short Squeeze?

A shift in market sentiment leading to a short squeeze can result in high losses for investors selling a stock. Sometimes a stock’s price action is determined by investors' sentiment rather than the company’s fundamentals.

A short squeeze occurs when an unexpected rise in the stock’s price makes numerous short sellers jittery. To avoid losses, short sellers exit positions by buying the stock, resulting in the price rising higher.

Benzinga details how a short squeeze works, why it happens and the factors investors need to consider to minimize the risks of falling into the short squeeze trap.

How Does a Short Squeeze Work?

Opening a short position means that you borrow shares of an asset you believe will decrease in value from a broker. You then sell the borrowed shares to an investor. When the price falls, you buy the shares from the open market and deliver them to the original owner to profit from the difference because the buy price is lower than the price you sold at.

Sellers make a loss when they buy shares at a higher price than their sell position. That happens when the price rises, instead of falling as traders expected.

A short squeeze starts when a company’s stock appeared to be in a downtrend (lower prices forming because of loss of value). Numerous traders open a sell position, believing they will profit from the falling price.

Although a stock’s price action suggests it will lose more value, a fundamental factor such as a better-than-expected earnings report is released and causes a price reversal. The stock’s price rises.

Not wanting to buy the shares at a higher price than the sell price, a small group of investors buys shares to close their positions. A larger group of investors notice that the price is rising and that some investors have closed their positions. They panic and then buy shares to close their positions to avoid losses.

Sellers closing their positions means they have bought the stock. The increased demand for the stock drives the price up further and a shift in the market occurs, making numerous traders believe that the stock is surging. To avoid missing out on profits, more traders buy the stock.

Why Short Squeezes Occur

Short squeezes occur with a shift in market sentiment. Most traders believe a stock will decrease in value, so they open a sell position. The share price initially decreases, earning them some profits. But an expected event such as a merger with another organization is announced.

The announcement makes the stock more valuable, so it sees a price increase. A few investors believe they will lose money if the stock continues to rise and then decide to close their positions. To close their positions, sellers need to buy the stock. That increases the stock’s value further.

More traders have shifted their sentiment from bearish to bullish, and they also close their positions out of fear of loss. The compounded demand creates a short squeeze and leads to a significant price increase.

Things to Consider With a Short Squeeze

Not all stocks that have slightly risen in value after falling prices are in a short squeeze. Traders should analyze the key factors to determine if the price is reversing.

Short Interest

Short interest helps traders gauge speculative stocks. It’s the total number of shares sold of the total shares outstanding, expressed as a percentage. Stable companies usually have a lower short interest than ones with speculative stocks. A sudden shift from a stock’s regular short interest could mean a shift in market sentiment.

Multiple Factors

When doing analysis, traders should strive for confluence — combining several strategies to determine the same outcome. Traders wishing to profit from a short squeeze shouldn’t rely only on short interest or another single indicator; they should combine several fundamental and technical factors to determine if a short squeeze is likely to occur.

What About Naked Short Selling?

The legal way to short a stock is by borrowing shares you don’t have to open a short position. Naked short selling is illegal because traders don’t borrow shares before opening a short position. It can happen because of discrepancies between paper and electronic trading.

The naked short seller sells shares not owned or confirmed to exist. The risk of naked short selling is failure to deliver. Because shares aren’t borrowed, a naked seller may fail to deliver the shares to the buyer if shares aren’t available when required to cover or close a position.

A Risky Situation

A short squeeze is a risky situation for investors selling a stock. When the share price unexpectedly rises, it triggers short sellers to rush to exit their positions, leading to even higher stock prices. Traders need to analyze key factors and exercise caution to navigate this situation wisely and minimize risks in the stock market.

Compare the Best Online Brokers for Short Selling

Being a seller in a short squeeze means that you need a broker to protect your position. Benzinga found the best online brokers enabling you to protect your account.

Frequently Asked Questions