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In Defiance Of Gravity: What's A Short Squeeze And Why Do They Happen?

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In Defiance Of Gravity: What's A Short Squeeze And Why Do They Happen?

Last year it was Tesla Inc (NASDAQ: TSLA).

So far this year, it’s been AMC Entertainment Holdings Inc (NYSE: AMC), GameStop Corp. (NYSE: GME), and American Airlines Group Inc (NASDAQ: AAL).

Anyone watching the markets and reading the news in January 2021 likely already knows what we’re talking about. All these stocks and several more felt the impact of what’s now very well-known terminology: the short squeeze and its options-related cousin, the so-called gamma squeeze.

See also: How to Short a Stock

A year ago, few people except market veterans would have known a short squeeze from a long jump. Now even your average college student has become familiar with the meaning—and may have actually participated in one (gulp!).

When this happens—as it did in a very big way with GME early in 2021—the consequences can be brutal for anyone on the wrong side of the trade. Those with a short position (meaning they won’t profit unless shares fall) can find themselves either holding on for dear life or forced to jump ship before potential losses pile up too high. 

In the case of GME, a surge in trading drove its value up by more than $10 billion on a single day. The next day, shares slid 44%. As noted by the New York Times, GME—a denizen of malls and shopping centers across the country—was worth about $2 billion in December. By January 27 it was worth $24 billion, roughly the same as the meat giant Tyson Foods, Inc. (NYSE: TSN) and the fuel refiner Valero Energy Corporation (NYSE: VLO). On paper, at least.

Why would something like this happen to TSLA, GME, or any other stock? There are a bunch of possible reasons, but a short squeeze is one of the main ones. 

Classic signs of a short squeeze can include:

  • A dynamic narrative, one that serves to “justify” the detachment of share prices from a company’s intrinsic value
  • A case for massive growth as well as a case for financial stress
  • Deep pockets lined up on both sides of the trade, often using options and other leveraged instruments

That last point may be of particular importance, as it can lead to a gamma squeeze (more on that in a bit). Leverage—whether it’s through trading on margin or the buying of out-of-the-money call options—is a double-edged sword. It can magnify losses as well as gains, and during a large-scale event such as a short squeeze, it can exacerbate moves to the upside as well as the downside.

In 2021, social media chatter also contributed to—and in some cases led—the squeezes in GME, AMC, AAL, and a number of other stocks that social media posters identified as having heavy short positions.

Caution Flag Warning

Before going further, if you’re a long-term investor who happens to hold a stock that’s getting squeezed, it’s probably not a good time to trade with emotions. Instead, remember what got you to where you are in your investing journey—and where you’d like to be. If participating in a stock that’s in squeeze territory doesn’t fall within your objectives, you might want to step aside.

But if you do want to venture in, make sure you have no illusions. Understand that when you’re dealing with a stock that’s being squeezed, you’re playing with fire. People who do that sometimes get burned.

Identifying a short squeeze is relatively simple—after the fact (see figure 1). The trick is to identify the conditions that could lead to a squeeze and determining how you might want to play it (or not). 

GameStop short squeeze, January 2021

FIGURE 1: GAMESTOP AND GO, AND DROP, AND WHOA! Shares of GameStop (GME) saw unprecedented volatility in early 2021 on an apparent short squeeze. Data source: NYSE. Chart source: the thinkorswim® platform from TD AmeritradeFor illustrative purposes only. Past performance does not guarantee future results.

The Short Squeeze’s Options-Related Cousin: Gamma Squeeze

Options traders know all about gamma, which tracks the sensitivity of delta to changes in the price of the underlying stock. (Here’s a crash course on gamma.) Without getting too deep into the weeds, some traders—and many market makers—hedge short delta positions with shares of the stock. For example, if a trader were to sell 10 call options that have a 0.20 delta, they might buy 200 shares of the underlying in order to stay so-called delta-neutral. (Remember the multiplier. Standard equity option contracts are deliverable into 100 shares of the underlying.)

But what if that stock goes to that short strike? That 0.20-delta call becomes a 0.50-delta call, which means the market maker is suddenly short the equivalent of 300 shares and needs to scramble to buy them. But the race to cover them pushes the stock even higher, and the option is now a 0.75-delta call ... then a 0.90-delta call ... and so on. Because the change in that delta is called gamma, the phenomenon is known as a gamma squeeze. As the stock rallies, market makers covering short deltas exacerbate the rally, which requires more shares to be covered in a feedback loop.

Gamma squeeze, short squeeze—it’s essentially the same scenario. You’re chasing the market higher to cover an exposure. And take note: If and when those positions unwind, the feedback loop can exacerbate moves to the downside as well.

The Short Squeeze Explained

You’re probably familiar with the terms “short selling,” “going short the stock market,” “shorting a stock,” or “selling stocks short.” The aim when shorting a stock is to generate profit from stocks that decline in value. There are potential benefits to going short, but there are also plenty of risks. One big risk is when bullish news pushes a stock price higher, prompting short sellers to head for the exits all at once. As the shorts scramble to buy back and cover their losses, upward momentum builds on itself and the stock can move sharply higher. 

This is known as a short squeeze.

What makes a short squeeze so dangerous? Think of it this way: When you buy a stock, the worst thing it can do is go to zero. But the upside is unlimited. If a stock has a growth narrative and there are enough believers, today’s share price can go well beyond what looks reasonable by traditional fundamental metrics.

On the other hand, to quote the old adage (widely attributed to economist John Maynard Keynes in the 1930s), “the market can stay irrational longer than you can stay solvent.” Even if a high-flier does come back to earth in the long run, the shorts may be wiped out long before then. (Or, in another quip by Lord Keynes, “in the long run, we are all dead.”)  

With GME in 2021—as with TSLA the previous year—there were all the classic signs of a short squeeze. People were covering because they had to. And that can cause things to get out of whack—when people make trades they don’t want to, but must.

When a stock suddenly climbs like a rocket even without good news, ask yourself, “Who would buy shares up here?” The answer? Someone who’s forced to. Someone who doesn’t have enough money to hold on any longer, or whose pain threshold has been violated.

The Squeeze Is On?

Again, shorting a stock is a complicated business. Because you can’t sell something you don’t own, shorting requires the seller to “borrow” the stock (and pay interest to the stock lender), then sell it. Locating the shares can sometimes be difficult for your clearing firm because of high demand or a small number of outstanding shares, called “the float” (see figure 2).

Measuring a short squeeze can involve a metric called the short interest ratio, aka “days to cover.” It indicates, in days, how long it would take to cover or buy back all the shorted shares. Basically, you divide the number of shares sold short by the average daily trading volume. The more days to cover, the more pronounced the effect can be.

Fundamental data for traders

FIGURE 2: VOLUME AND FLOAT. Fundamental data available on tdameritrade.com can help you analyze the dynamics of a stock’s price action. Source: tdameritrade.com. For illustrative purposes only. Past performance does not guarantee future results.

Technical Analysis And Short Squeezes

When markets have explosive activity, it’s easy to see in hindsight. But there are also tools that can help identify when momentum builds so you don’t end up on the wrong side of the trade. On the thinkorswim platform from TD Ameritrade, an indicator called TTM Squeeze can help highlight when the transition between a consolidation and a trend is likely to take place. To see it, pull up a chart from the Charts tab on thinkorswim and select Studies > Add Study > All Studies > T–U > TTM_Squeeze. In figure 3, the TTM Squeeze is plotted in the subchart below the price chart. 

Short squeeze and TTM indicator

FIGURE 3: SQUEEZE ILLUSTRATED. After a period of compression, Tesla stock (TSLA, candlesticks) started showing signs in early 2020 that perhaps it would start making an upward move. In early October 2019, the TTM Squeeze indicator (subchart) showed momentum building up in the stock. This coincided with the stock moving above its 20-period moving average (blue line). The stock continued its upward move and then exploded well above the moving average. Data source: Nasdaq. Chart source: the thinkorswim platform from TD AmeritradeFor illustrative purposes only. Past performance does not guarantee future results.

The indicator (dots along the zero line) is plotted with a momentum oscillator (cyan vertical bars). Notice how the oscillator gradually started moving above the zero line and the histogram bars were getting taller? This indicated a possible buildup of momentum. The dots plotted on the zero line are green, which suggests the market is ready to trend. Red dots suggest the market is tightening. If momentum is above the zero line, the direction of price movement is up. When it’s below the zero line, price movement is likely to be down. It may be helpful to plot an additional indicator such as a moving average to confirm the trend.

In this case, the momentum was clearly building for an uptrend. The momentum became extremely strong, pushing the stock price significantly higher. When might it slow down? Keep an eye on the TTM Squeeze indicator.

The Short Squeeze Hall Of Fame

In addition to Tesla and the drought-led short squeeze in the grain markets in 2012, there have been quite a few instances when shorts piled in, only to wave the white flag after a monster rally.

In one famous short squeeze back in October 2008, Volkswagen—a decent-size company but normally not one people tend to think of as a market juggernaut—temporarily became the world’s most valuable company as it rose to 1,005 euros per share from just over 210 in less than two days.

The value of Volkswagen shares hit $370 billion, which at that time was enough to top Exxon Mobil Corporation’s (NYSE: XOM) $343 billion market cap. Shorts scurried out of VW shares as short sellers caught betting on a price drop with borrowed stock scrambled to find shares after a buying spree by Porsche, as Reuters reported at the time.

Another famous story includes a pair of New York railroad squeezes beginning in 1863 (“Harlem Corners 1 and 2”) that pitted Cornelius Vanderbilt against several rivals who tried to short his New York & Harlem railway into bankruptcy. With his combination of market savvy and deep pockets, “Commodore” Vanderbilt walked away the victor.

Fundamental Files

If you’re buying a stock that seems to be in the throes of a short squeeze, especially at high levels, it helps to understand any other reasons why the stock might be moving. 

Consider checking the fundamentals. Is there anything that makes you want to own the stock? You’re not just tempted to buy it because everyone else is, right? Always do your homework. And remember, there’s no need to go all in. A stock that’s in a short squeeze may still have a long way to climb, and if you don’t think the fundamentals support higher prices, then perhaps you should look elsewhere.

In the case of TSLA in 2020, there were some positive fundamentals underlying the short squeeze, including the company’s more consistent profitability and hopes of it being included in the S&P 500 Index (SPX). The stock saw its share price run up to new highs, then down nearly 60%. 

But then TSLA rallied again. And split its shares. And then its addition to the SPX became a reality. So the short squeeze isn’t always followed by a fizzle and flame-out. Your mileage may vary, as the commercials always say.

Other stocks that were caught up in short squeezes haven’t always fared so well, in part because they didn’t have the fundamental support. As with the famous Dutch tulips, there was a vast crater waiting for those who held on too long. 

Playing The Squeeze? Hope You’re Comfortable With Risk

So you say you want to play a stock during what might be a short squeeze? Here’s some stuff to consider.

Trading such a stock is okay as long as you understand the risk and how to control it. You can make small or big bets, but you have to control the risk and limit it. Decide how much money you would be comfortable losing in any trade.

Also, don’t underestimate how far things can go and how long it can take. When a stock gets caught up in a short squeeze, analysts generally expect it to correct eventually, but to what price and when? Those are the questions no one can answer.

These things can drag on. Just look at the drought of 2012 in the grain markets. Grain futures rose further than anyone thought they could and stayed there awhile. It was a short squeeze based on lack of volume, a drought that caused demand to go crazy, and speculation running rampant.

Considering a play in the options market during a short squeeze? Again, know what you’re getting into. Selling single-leg options is quite risky. Consider instead selling a vertical spread (here’s more about limited-risk options strategies). And if you’re buying options, know that during volatile times, options prices can become very expensive. 

And remember: A short squeeze doesn’t last forever. Most eventually subside.

Photo by SpaceX on Unsplash

 

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