What Is a Short Squeeze?
An uncommon circumstance known as a “short squeeze” causes the price of stocks or other tradable securities to rise quickly. It happens when there are a lot of short sellers of a security, which indicates that many investors are placing bets on the asset’s price dropping. When the price suddenly spikes upward and gathers traction as a sizable portion of short sellers choose to reduce losses and liquidate their holdings, this is known as the short squeeze.
How Does a Short Squeeze Work?
In the event of an unexpected price increase in a highly shorted company, short sellers may need to move quickly to minimize their losses. Short sellers borrow those shares to purchase shares of an asset after it declines in value. If they are correct, they give back the shares and pocket the difference between the price at which they started the short position and the price at which they purchased the shares back to end it. If they are mistaken, they must pay the difference between the selected price and the item’s selling price and purchase it at a more significant cost.
Prices rise due to the concurrent departure of short sellers, who leave their positions with purchase orders. The security’s price is drawing purchasers in addition to its fast growth. A startling and unheard-of price increase might result from frantic short sellers giving way to eager purchasers.
A short squeeze is the flight of short sellers and their effect on the price of a company. Squeezing short sellers out of their positions often results in a loss.
Short sellers focus on a stock that they believe the market has overvalued. For instance, Tesla Inc. (TSLA) piqued the interest of several investors with its creative approach to manufacturing and selling electric cars. Investors extensively gambled on its potential. Short sellers made significant bets on its downfall. With almost 18% of its outstanding shares held in short positions at the beginning of 2020, Tesla was the most shorted company in American markets.1.
The price of Tesla shares increased 400% between late 2019 and early 2020. The short sellers suffered a great deal, losing almost $8 billion in total.1. Finally, after a market dip in early March 2020, Tesla’s shares dropped along with most others. But in the end, the market recovered, and short sellers of Tesla are now facing combined losses of almost $40 billion in 2020.
Reasons for Short Squeezes
As said, short sellers initiate positions in companies they predict will see a price decrease. However, persuading reasoning, a good news story, a brand-new item, or an earnings beat that piques consumers’ interest may reverse this.
The stock’s recent upward trend might only last temporarily. If not, however, short sellers may experience uncontrollable losses as the expiration date of their bets draws near. They usually choose to sell out immediately, even if it means suffering a loss.
18%
The fraction of Tesla shares showed short interest towards the end of 2019. Short sellers lost millions as its stock price tripled.
That is the application of the short squeeze. Each time a short seller purchases anything, the price rises, and another short seller is compelled to buy.
Particular Points to Remember
The short interest ratio and short interest are helpful metrics for determining whether companies are susceptible to a short squeeze.
The proportion of outstanding shares sold short is known as short interest. The total number of shares sold short divided by the average daily trading volume of the company yields the short interest ratio. Unlike more solid corporations, speculative equities often have more short interest.
You can determine if investor perceptions of a firm shift by focusing on short interest. For instance, a rise above or below the range usually indicates a 15% to 30% short interest in a stock, which might indicate a change in investors’ perceptions of the firm. A decrease in short shares may indicate that the company has become too steady for short sellers to stay in or that the price has increased too rapidly.
A favorable news story, a new product release, or an earnings beat that piques customers’ interest may defeat a short position.
An increase in short interest higher than average suggests investors are becoming more pessimistic. However, a high reading might indicate an impending short squeeze that would drive up the price.
Taking a Shot at a Short Squeeze
A contrarian investor would purchase a stock with a high volume of short sales to take advantage of a possible short squeeze. Although a sharp increase in stock prices is alluring, hazards are involved. There might be a valid reason why the company is extensively shorted, such as a bleak future forecast.
Active traders who are waiting for a price increase will monitor highly shorted stocks. The trader buys as the price starts to gain momentum to profit from what may be a short squeeze and a significant increase in value.
The Dangers of Short-Squeeze Trading
Several instances of equities rising in value after a significant increase in short interest. However, a lot of highly shorted equities also see continuous price declines.
The price may stay the same despite a high level of short interest. It indicates that a lot of people think it will collapse. Those who purchase expecting a short squeeze need to have more compelling arguments than just a rising stock price.
Short Squeeze vs. Naked Short Selling
Selling a stock for a short profit without obtaining a loan from someone else is known as naked short selling. Selling shares that have yet to be confirmed to exist is the practice in question. The Securities and Exchange Commission (SEC) of the United States forbids selling naked shorts. The naked shorting strategy has enormous payoff potential and a significant risk.
Naked shorting still occurs because of the differences between electronic and paper trading. Because naked shorting makes it possible for extra shorting to occur that could not have otherwise, it can assist in intensifying short squeezes. It’s said that naked shortselling aids in market equilibrium. In other words, naked shorting can drive a price decline that prompts some share sales to offset losses and, ultimately, helps the market achieve equilibrium.
A Short Squeeze Example
Consider Medicom, a fictitious biotech business pursuing a medication candidate through advanced clinical studies.
Investors are still determining if this medication will be effective. Consequently, there’s a lot of short-term interest. Of the 25 million shares that Medicom has outstanding, 5 million have been sold. This indicates that Medicom has a 20% short interest and a five short interest ratio based on an average daily trading volume of one million shares. Days to Cover, another name for the short interest ratio, indicates that it will take five days for short sellers to repurchase all of the Medicom shares that were sold short.
Assume Medicom shares dropped from $15 a few months ago to $5 due to the significant short interest. Subsequently, word spread that Medicom’s medication performed better than anticipated. As sellers rush to cover their short positions and speculators purchase the company, Medicom’s shares soar to $9.
Now, everyone who shorted the stock between $9 and $5 is losing money. Because they are losing 80% of their investment, those who sold short around $5 will be suffering the most significant losses and will be rushing to exit.
The stock starts out at $9, but it will increase over the next few days as more buyers become interested in it due to the rising price and encouraging news while short sellers continue to cover their holdings.
Squeeze GameStop Short
There was a significant short squeeze among investors and traders of GameStop Corp. (GME) in the months that followed the COVID-19 epidemic. A surge in competition and reduced foot traffic at brick-and-mortar shops meant analysts and investors anticipated the firm would face bankruptcy, with customers locked down and locations often shuttered. Short sellers started to attack GME often. The short interest exceeded 100% of the outstanding shares due to its rapid increase.
This prompted Michael Burry of Scion Asset Management to create a bull case for the business, arguing that it might earn a profit in a few years rather than filing for bankruptcy. Midway through 2020, Reddit and YouTube content providers publicized and reiterated his argument. Ryan Cohen, another co-founder of Chewy, and Michael Burry also took a lengthy stance.
Late in 2020, enough investors began purchasing the shares, and the share price started to grow significantly. After that, ordinary investors’ purchase of shares and call options had a snowball effect. Elon Musk and venture capitalist Chamath Palihapitiya were among the prominent investors and public personalities drawn to the price hike, pushing out some short sellers.
Due to a short squeeze on significant hedge funds that were short the company and had to sell to reduce losses, GameStop’s stock price spiked. The stock price increased from less than $5 a share in one month to $325.
How Do Days to Cover Help in Determining Short Squeeze Targets?
Days to cover, also referred to as the short interest ratio, is computed by dividing the total number of shares sold short of a company by the average daily trading volume of the stock. For instance, the number of days to cover would be ten if a company had one million shares sold short and 100,000 shares traded on average daily. Based on the average daily number of shares traded, short sellers would take ten days to cover their short position. A stock is often more vulnerable to a short squeeze the greater its days-to-cover ratio. Stock B might be more susceptible to a short squeeze if stocks A and B have two and twenty days to cover.
A Short Squeeze: Who Wins and Who Loses?
If a stock experiences a short squeeze, traders and speculators with short positions in the stock will suffer significant losses. As the stock price rises, contrarian investors who have amassed long positions in the company in expectation of a short squeeze will profit.
Where do I look for information about highly shorted stocks?
Free stock screeners are on finance websites like Yahoo! Finance, which provide lists of significantly shorted equities. Upon further exploration of individual stocks, pertinent short-selling data is shown, including the number of shares sold short and the short interest ratios for certain businesses. Useful short-selling statistics, such as the most significant short-interest positions, changes in such positions over time, and the short-interest ratio, may be found on websites like MarketBeat. Exchanges like the Nasdaq and the New York Stock Exchange also release data on short interest for the whole exchange.
Which Short Squeeze Was the Biggest in History?
Porsche Automobile Holding SE (POAHY), a significant shareholder in Volkswagen AG (VWAGY), raised its overall ownership of Volkswagen to around 75% during the 2008 financial crisis. Additionally, the state of Lower Saxony held over 20 percent of the business, meaning that when the stock was massively shorted, there were few shares left for trading. Due to Porsche’s action, not all hedge funds and other short sellers could cover their bets, which put them in a difficult situation. In light of this, short sellers were compelled to repurchase the shares they had sold, contributing to Volkswagen’s stock rising to €999.
The Final Word
With a parabolic price increase, a short squeeze may appear out of nowhere. However, exceptionally significant short interest in the underlying security often drives short squeezes. When the stock price rises due to an event, short sellers quickly try to sell and close their positions by trying to purchase the shares. This intensifies the factor driving the stock price upward, leading to the onset of irrationality. An excellent illustration of a short squeeze in action is what occurred to Game Stop’s share price in 2021.
Conclusion
- When a stock experiences a short squeeze—many people are betting against it—its price surges instead.
- A short squeeze occurs when short sellers pull out to reduce their losses, which drives the stock price.
- Investors that follow the other path attempt to predict a short squeeze and purchase equities with a high level of short interest.
- Contrarians and short sellers both take unnecessary risks. There are other reasons why a prudent investor might short or purchase that stock.
