What Is a Short Squeeze and How Do They Impact Traders?

The Importance of Understanding Short Squeezes

If you’ve ever seen the film The Big Short, you may be familiar with the term ‘short squeeze’. With short squeezes related to major moments within economic markets and cultural movements in recent years, understanding what short squeezes are is a crucial part of every investor’s journey.

What is a Short Squeeze?

A short squeeze triggers fast-rising prices across a stock’s value, or that of another tradable security. Short squeezes occur when a single security has a high volume of short sellers, positioning a multitude of investors to potentially benefit from their bet that the stock’s price will fall. The short squeeze takes place when the price sees an unexpected lift, gaining momentum as a large number of short sellers look to mitigate their losses and exit their positions.

How Does a Short Squeeze Work?

If a stock that’s been heavily shorted experiences a sudden, unexpected rise in price, short sellers are faced with two options: sell quickly in the hopes of limiting their losses, or ride out the market in the hopes the stock will take a downwards turn. As short sellers are often reliant on decreasing stock values in order to see a return on their investment, many will look to close their position and limit further losses, buying the stock at a higher price than they paid and losing the difference between the price they set and their final sale price.

As short sellers can only exit their positions through buy orders, the exit of numerous short sellers leads to higher prices, which can also attract buyers to the stock or security. Through a combination of new buyers entering the market, alongside short sellers who are urgently looking to minimise their loss, a short squeeze can occur, leading to a significant and fast-paced rise in price that may be unprecedented in the market.

Why and How Do Short Squeezes Happen?

As short sellers are speculating in the positions they open on stocks, believing that the stock will decline in price, a swift turn in the fate of that stock can lead to significant exposure to risk. For example, a positive market trend that supports an increase in that stock’s value or a lauded product announcement can be enough to send stock values upwards. While this may be a temporary shift in an otherwise downwards-trending stock, short sellers face the risk that this shift in fortune may continue, exposing them to significant losses as the expiration date on their positions gets closer. For many short sellers, this will lead to an immediate choice to sell, even if it means realising their loss.

This is where short squeezes begin - with every sale by a short seller leading to an increase in price, creating further losses for the next short seller to close their position.

Who Loses and Who Benefits from a Short Squeeze?

One group of investors who may see benefits from a short squeeze are contrarian investors. This is a type of investment strategy that sees investors intentionally going against market trends - selling when others are buying and buying when the majority of investors are selling. The ethos behind contrarian investments is that those who believe the market is going up will only state that belief when they’re fully invested with no more access to purchasing power, defining a market at its peak. This logic follows the belief that if the majority of investors are predicting a downturn, they’re likely to have already sold out, meaning the market has no other alternative but to go up.

During short squeezes, contrarian investors may purchase stocks with heavy short interest in order to exploit the potential should a short squeeze occur. In this instance, a fast rise in stock price is a positive for the contrarian investor. However, this strategy, as with any investment strategy, brings inherent risk, with stocks likely shorted for a good reason.

Short sellers ultimately stand to lose out during short squeezes, forced to buy stocks at a higher rate than anticipated in order to mitigate continued, potentially unprecedented losses.

Short Squeeze Indicators

While short squeezes are often marked by their unpredictability, there are a number of signs that can point to the likely event of a short squeeze. These include:

Notable amounts of buying pressure. If any stock suddenly experiences a sharp increase in the overall number of shares bought, this may be one of the first signs of a likely short squeeze to follow.

High short interest rates that are at 20% or above. Short interest refers to the percentage of the total number of outstanding shares held by short-sellers. Higher short interest percentages indicate larger numbers of a stock’s outstanding shares are being sold short. As this percentage continues to rise, so does the likelihood of a short squeeze occurring.

High Short Interest ratio or days to cover above 10. A Short Interest ratio (SIR) is a comparison of short interest to the average daily trading volume, creating a theoretical representation of how many short-sellers would need to exit their positions across the average trading volume. If this number increases, it can also point to a likely short squeeze.

Relative Strength Index below 30. Relative Strength Index (RSI) is a way of monitoring overbought or oversold conditions in the market across a scale from 0 to 100. If a stock has a low RSI, it’s likely it’s oversold, with the possibility of an increase. A high RSI points to the likelihood that the stock is overbought, with a potential drop on its way.

Naked Short Selling vs. Short Squeeze

While naked short selling and short squeezes may share similar characteristics, there are key differences between the two. Naked short selling refers to the act of short selling a stock without first securing the underlying asset from someone else via a loan. This is an illegal activity per the US Securities and Exchange Commission.

However, naked shorting still takes place due to the gaps between electronic and paper trading. As naked shorting leads to a false account of the amount of stocks available for trade, the practice can make a short squeeze worse, enabling additional shorting that otherwise wouldn’t be able to add pressure to the market. Naked shorting can also force price drops, which can be of use in enabling the market to find equilibrium.

Example of a Short Squeeze

One clear example of a short squeeze is seen in the GameStop Short Squeeze of 2021. Due to rising competitors and less foot traffic within physical retailers, GameStop Corp. (GME) became a target for short sellers, with the short interest rising to more than 100% of outstanding shares. At this point, Reddit intervened, joining a bull case for the company in the belief that it could return to profit within a matter of years. This led to a number of major investors taking a long position alongside individual investors.

Consequential price increases placed significant pressures on numerous short sellers, with the stock price surging due to a short squeeze, impacting major hedge funds. Many were forced to sell in order to cut their losses, with GameStop’s stock price rising from under $5 a share to $325 a stock in a single month.

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