What is a Short Squeeze?
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To understand what a short squeeze is, you need to understand short selling. The actions of short sellers are one of the key causes that mean a short squeeze can happen.
I. What is short selling?
Short selling is a way of betting on a stock price to fall.
In simple terms, when you decide to go short on a stock, you rent a share and sell it on the market at its current price.
Your hope is that the stock price then falls, so you can buy the share back later at a lower price, give the share back and make a profit on the difference.
If you’re wrong and the price goes up, it can start to get very expensive as you still owe your broker the share. Sometimes a group of investors or a hedge fund can short a lot of shares, leaving them at risk if the price increases and vulnerable to something called the ‘short squeeze’.
II. What is short squeezing?
A short squeeze happens when a stock price rises rapidly, forcing short sellers to buy more shares.
If someone is ‘short’ a lot of shares in a stock that experiences a rapid price increase, brokers can get nervous about their ability to repay the debt. When this happens, they can demand the shorter ‘closes’ their position by buying back the shares and repaying them.
Sometimes it can be the short sellers themselves who get nervous and want to get out of their position. As the stock rises they might decide to take their losses and avoid an even bigger one.
Of course, when a short is forced to buy those shares to close out their position, this only increases demand and pushes the price up even more. This can happen particularly when a very high percentage of a stock’s shares are shorted.
III. What causes short squeezing?
In a short squeeze, people who are both ‘long’ and ‘short’ want to buy more shares, pushing the price up even more.
When the share price of a stock that’s been heavily shorted rises quickly, it can put pressure on the short sellers to close out their positions. This surge in demand to buy new shares causes another jump in price, which can cause even more shorters to be squeezed out.
GameStop is one of the most famous recent examples of a short squeeze in action.
- The hedge fund, Melvin Capital, thought GameStop was a bad investment and decided to go short, selling shares with the hope of buying them back later
- Retail investors responded by going ‘long’, buying a lot of shares
- With significantly more buyers than sellers, GameStop’s share price rose very quickly
- As the shorts began closing their positions, both the ‘long’ retail investors and the ‘short’ hedge funds wanted to buy shares
- With even more demand, the price continued to rise rapidly, ‘squeezing’ out the short sellers
A way to judge how vulnerable a stock is to be short squeezed is by looking at the number of shares short (i.e. borrowed but not yet repaid) as a percentage of the total number. The higher the percentage, the more chance there is of it experiencing a short squeeze.
Stocks that experience a short squeeze can see a series of rapid jumps in price, as each increase squeezes more short sellers and forces them to buy more shares to close out.
IV. Is short squeezing good or bad?
Every situation is different, but short squeezes make a stock very volatile.
A short squeeze can be a sign of a volatile stock, but it isn’t necessarily a bad thing (except for the short sellers!) as it can be caused by a whole range of different factors.
A significant development or change in circumstances could be a sign that the short sellers were simply wrong about the stock. A popular company with a good news story can generate enough interest from ‘retail’ investors to push the price up and cause a short squeeze.
Short squeezes can also be engineered as a way of fighting back against the ‘negativity’ of the short sellers. If enough people band together and start buying a stock to push the price up, it can cause the shorts to get out before they incur heavy losses.
V. Should I participate in a short squeeze?
Joining in with a short squeeze can be extremely risky and can lead to heavy losses.
Short squeezing introduces a lot of uncertainty and risk into investing. When it’s done successfully, it can lead to big gains, but it can also cause serious losses if you don’t get it right or join in at the wrong time.
There can be good reasons for investors to be short a stock. The fundamental market conditions might look bad for the company, it might have poor leadership, or it might be experiencing legal or regulatory challenges.
Going up against short sellers can be risky, as the fact of their presence introduces a lot more volatility to the stock. If there are signs their concerns are going to be proven right, it can cause the stock to fall very quickly.
It’s true that a short squeeze can offer up opportunities to benefit from a steep price rise. You should always be aware of the risks, make sure to research around the company, and understand why you think the short sellers are wrong.
It’s also important to be familiar with short-term trading, as you’re probably going to have to react to fast-moving events. Consider things like your broker’s trading fees as that can eat into your profits if you make a lot of trades.
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