What is a short squeeze?

During the height of the meme stock frenzy, you might have heard the buzzword “short squeeze” a few times. But what does it mean? We’ll break it down for you – but first, we need to explain short selling for you to understand the full picture.

What is a short selling?

When you hear of an investor shorting a stock, it means the investor is betting against that stock. In other words, the investor believes the share price of the stock will drop.

In technical terms, “short” in financial markets refers to initiating a sell position, and that’s where the term short selling comes from. Most often associated with the stock market, it involves borrowing a stock from a broker and then selling the stock at its current price with the hope to buy it back later at a lower price to return it to your lender, with the goal of profiting from the predicted decline in the stock.

It’s important to understand that short sellers do not own the stock they are selling short. When someone short sells a stock, they’re actually borrowing shares from a broker and immediately selling them on the market. This creates an interesting situation where the short seller has an obligation to eventually buy and return those borrowed shares.

What is an example of short selling?

Say you’re an investor who wants to short 100 shares of ABC stock at its current market price of $20, as you expect the stock to fall in value over the near term. You borrow the 100 shares from your broker and sell them to a buyer. The buyer pays you $2,000, which is credited to your account.

To do this you’ll need a margin account to borrow the shares, and you’ll pay interest on the value of the shares you sell as you wait and hope for the price to drop in the future.

If ABC’s share price falls to $15, then you, the short seller, can buy the 100 shares back at a cost of $1,500 and return them to the lender (broker). The difference – in this case, $500 minus the costs to implement the short (such as the borrowing cost) – will be your profit.

However, if the price of ABC increases, then you would lose money. Since stock markets tend to rise over time, this strategy is inherently riskier than the traditional strategy of buying first and selling later.

Who participates in short selling?

Highly experienced traders seeking short-term gains may look for short-selling opportunities, though this can carry a lot of risk.

Investors participating in short selling may look for signs that a stock will drop in the future caused by any number of things including bad earnings expectations, unfavorable legal or regulatory findings or product problems.

Investors who do not have a very high risk tolerance and thorough understanding of investing and the markets should first consider a long-term buy-and-hold strategy.

What are the risks of short selling?

While the potential profit can make short selling tempting, you shouldn’t ignore the substantial risks involved that can come from short selling. Here are some to consider.

Market volatility

One of the significant dangers of short selling is the market’s volatility during a short squeeze. Prices can swing dramatically in either direction, sometimes within minutes, making it easy to make costly mistakes.

Timing

Another major risk is timing. Successfully short selling requires precise timing to enter and exit at the right moments. Missing those windows could mean getting caught in a stock’s rapid descent just as quickly as it rose.

Margin calls

If a short seller’s borrowed stock’s price rises significantly, they may be forced to deposit additional funds or close their position at a loss. This risk can be particularly acute during market rallies or short squeezes.

Interest expenses

Short sellers must pay interest on the borrowed shares for the duration of their position. These interest costs can significantly erode potential profits, especially in long-term positions, as they compound over time and directly reduce the net return.

Being wrong

If short sellers incorrectly predict a stock’s movement, they face theoretically unlimited losses as the stock price can rise indefinitely. Margin requirements, interest expenses, and potential recall notices from lenders demanding the return of the borrowed shares will compound this risk.

What is a short squeeze?

Short selling comes with significant risks. This is where the concept of a short squeeze becomes relevant.

The simplest short squeeze definition is when a heavily shorted stock’s price unexpectedly rises instead of falling. This increase often happens because of positive news about the company or a surge in demand for the stock, sometimes driven by retail investors.

When the price starts rising, short sellers are caught in a tough spot. To limit their losses, they typically aim to close their positions by buying back the shares, and this sudden buying pressure drives the stock price even higher. The higher it goes, the more short sellers are “squeezed” out, further fueling the increase in demand and amplifying the price surge.

This can spiral quickly, creating a dramatic upward price movement in a short period. This is what traders describe as a short squeeze – a situation where the stock’s rapid climb, which could be propelled by short sellers scrambling to exit their trades or any number of factors that could swing the price.

While a short squeeze may offer the opportunity for potential gains to investors not involved in short selling, these events can be highly volatile and risky for all parties. Staying invested over the long term may help hedge against periods of volatility in the market.

What’s a real life example of a short squeeze?

Essentially, a short squeeze occurs when short sellers start to panic because the price of the stock they shorted increases. They’re on the hook to return shares but at much higher prices. This demand to buy drives the stock price higher, creating a feedback loop of rising prices. It’s a financial chain reaction where market dynamics and fear collide, leaving short sellers scrambling as the stock rises, evaporating their expected profit and potential rising beyond the price they sold the shares, meaning they’re actually losing money. All the while they’re paying interest on the value of the shares they sold.

Short squeezes have gotten a lot of attention due to the meme stock frenzy surrounding GameStop in 2021, when retail investors on social media rallied together to drive the stock price up. However, perhaps, the most famous example of a short squeeze involved two automakers: Volkswagen and Porsche.

In 2008, Porsche announced that it planned to acquire Volkswagen, which sent the latter’s share price skyrocketing and quadrupling in price in about two days.

While the intent to acquire usually results in movement – either up or down – in the stock prices of both the acquiring and target companies as the market tries to find the true value of the merged entity, the extreme moves witnessed in this case were attributed to hedge funds frantically trying to cover their short positions.

Aside from the surprise announcement, news that “there was less than 6% of [Volkswagen] voting stock still floating in the market” caused short sellers to rush to buy back their shorted shares.

This squeezing of the shorts led to shares being priced as high as 1,005 euros per share and briefly made Volkswagen the world's biggest company in terms of market value.

How to identify a short squeeze

A short squeeze can be an exciting, yet high-stakes, event in the financial markets. For investors, spotting the signs of a potential short squeeze can present a significant opportunity to capitalize on market dynamics.

Here are some key indicators that a stock is potentially ripe for a short squeeze:

Large number of short sellers

One of the primary indicators that a short squeeze may occur is a large number of short sellers targeting the stock. Unlike long-term buy-and-hold investors, short sellers are obligated to buy back the shares they sold to return them to the lender. This process can create a scenario in which short sellers could be forced to cover their positions if the stock price rises, driving up demand for the shares.

To evaluate whether a stock is heavily shorted, investors often use the short interest percentage – a commonly available metric that measures the portion of outstanding shares, also known as the “float,” currently sold short.

While the definition of a “highly shorted” stock varies, the market consensus suggests that stocks with short interest percentages exceeding 10% of the float could be vulnerable to a short squeeze.

Unusual trading volume

Unusual trading volume can also offer important clues about an impending short squeeze. A spike in trading volume, particularly during upward price movement, signals increased buying pressure.

This could suggest that short sellers are beginning to cover their positions or that bullish sentiment is escalating, both of which can initiate or accelerate a short squeeze. Monitoring sudden surges in volume compared to the stock's historical averages can provide additional context for investors.

Positive news event or another catalyst

A short squeeze often requires a trigger – or catalyst – that drives the stock’s price higher. Positive company news, such as earnings beating expectations, the approval of a new product or the announcement of a significant partnership, can cause the stock price to surge unexpectedly.

Even external events, like changes in industry standards or regulatory decisions, can serve as a catalyst.

Monitoring social sentiment

Recent market events have shown the influence of social media on short squeezes. Some platforms can amplify discussions about heavily shorted stocks among retail investors.

An overwhelming buzz or a coordinated effort to drive attention toward a particular stock can create rapid price increases, sparking a short squeeze.

While investors should always approach social sentiment with caution, monitoring online activity may offer insights into emerging trends that may not yet be evident in the markets.

Misinformation

There’s also the challenge of misinformation. Stocks undergoing a potential squeeze often attract incredible levels of hype, particularly on online forums and social media.

Unfortunately, this can lead to inflated expectations, confusion and poorly informed decisions. Traders should exercise caution when considering sources of information and should conduct independent research before making any moves.

What you can do if you find yourself caught in a short squeeze

Whether you’re short trading a stock or find yourself owning a stock caught in the short squeeze, knowing how to avoid heavy losses during a short squeeze may help you prevent a major drop in the value of your investments. Here are some tips if you find yourself caught in a short squeeze or watching a short squeeze from the sidelines.

Maintain perspective

A short squeeze can cause extreme price volatility. Avoid making panic-driven decisions, especially if your investing strategy is a long-term buy-and-hold strategy and you’ve simply found yourself exposed to a short squeeze. The dramatic price increases during a squeeze are often temporary.

Don’t try to time the market

Timing the market is historically very difficult, even for the most experienced investors. If you find yourself exposed to a short squeeze, avoid trying to time it perfectly to limit your risk.

Don’t get caught up in the hype

Short squeezes can be very public events. If you find yourself caught in a short squeeze, including by happenstance, do your best not to get caught up in the hype so you can make the best financial decisions for your individual situation.

The bottom line

Trying to benefit from a short squeeze situation can be a very risky strategy, which requires understanding both the mechanics and the psychology of the market. It's about knowing what drives investors to take certain actions and how the ripple effects intensify the situation.

Short squeezes represent a fascinating intersection of strategy, risk and opportunity, but they aren’t for everyone. For experienced speculative traders, the potential for gains may justify the risks, but for those new to the market or for long term investors, a squeeze can quickly become overwhelming and costly.

For all trading decisions, remember investing involves market risk, including possible loss of principal, and there is no guarantee that investment objectives will be achieved. Shorting stocks is highly risky. Do your research and assess your risk tolerance before considering dipping your toes in.

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