Have you ever taken a bet that went south? In the simplest of terms, that’s what a short squeeze is. Short sellers take a gamble betting that a stock will decline, but when unexpected news arises—or retail traders swoop in to buy the stock—the stock price could increase, squeezing the short-sellers out.
One of the most recent examples of a short squeeze that made headlines is GameStop. The WallStreetBets Reddit community triggered a short squeeze as they bought the heavily shorted stock, causing short sellers massive losses.
A Brief Overview of Short Selling
Short selling is a method of trading where you bet that a stock’s price declines. The idea is you borrow stocks to sell, then plan to buy them back at a lower price to return them. To successfully short sell, you would need to:
- Borrow the stock
- Sell the stock
- Buy the stock at a lower price
- Return the borrowed shares and keep the profit
An example is borrowing a stock and selling it at $100 per share. You wait for the stock to decline, and buy it back at $75 per share, then return the shares you borrowed. Not including fees, you would earn a $25 profit per share.
Traders can use short selling just to speculate or bet that it will decline, or hedge a position. While all trading carries a level of risk, this method is very risky, because you can theoretically lose an unlimited amount of money.
This method of trading can bring in large profits, but can also bring in large losses. At a certain point, you will need to return the shares you borrowed, and if the stock is increasing in price, you will have to cover yourself and buy the stocks at a higher price to return, causing you to lose money.
Read More: What is Short Selling?
What is a Short Squeeze?
A short squeeze happens when a highly shorted stock doesn’t decline but rapidly increases. This traps the short-sellers, forcing them to close their position to prevent further losses. When the short sellers buy the stock to cover their losses, it only adds even more upward movement for the stock.
An example of this is borrowing the stock at $100 per share. You wait for it to decline, however, the stock rapidly increases in price to $150. In this scenario, either you are approaching your expiration date or you want to cover to prevent further losses, so you buy the shares at $150. Without including fees, you are at a loss of $50 per share.
Why Do Short Squeezes Happen?
Short squeezes occur when the bets of the short sellers go south, and they have to cover their loss. This can happen for a variety of reasons, like positive news, an unexpected announcement, earnings reports, or even because of an influx of buyers as seen in GameStop.
While this price increase could be temporary, it’s not always the case. Plus, short-sellers usually have a deadline they have to return the stocks by.
So when short sellers start buying shares to return to the borrower, it sends the price up higher, causing even more short sellers to do the same thing.
Which Stocks Are Highly Shorted?
To find stocks that are highly shorted and could fall into a short squeeze, you’ll want to look for short interest and short-interest ratio. Short interest is the total number of shares sold short as a percentage of total shares outstanding.
What is considered highly shorted depends on the stock and overall market, but typically double-digit short interest is considered high.
Some traders will actively look for highly shorted stocks to see if they can take advantage of price action on a short squeeze.
Risks of Trading Short Squeezes
Just because a stock is highly shorted does not mean a short squeeze will occur. If you are going to buy a highly shorted stock, you should have a reason to do so other than the potential for a short squeeze. You might buy a stock thinking it could be a short squeeze, and then the stock rapidly declines, causing you losses on your trade.
Short squeezes are just one of the risks of short selling stocks. If you are a short-seller, this is something to keep in mind before you make your trade. If you are a trader, looking out for short squeezes is a way to find opportunities to take advantage of price action.
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