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Short Squeeze

Guide to Understanding the Short Squeeze Concept

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Short Squeeze

How a Short Squeeze Works (Step-by-Step)

A short squeeze is initiated by the share price of a company with significant short interest (i.e. investors holding short positions) increasing, which causes short sellers to exit, creating a positive feedback loop where the share price continues to rise.

In a short squeeze, a positive catalyst such as an unexpectedly strong earnings announcement causes a company’s share price to rise, and short-sellers run for the exit to cut their losses.

Before a short squeeze takes place, the general sentiment surrounding the underlying company’s outlook is disproportionally negative.

So in anticipation of the current share price continuing to fall, a significant amount of short interest mounts up among investors.

However, in a short squeeze, the company’s share price unexpectedly increases instead, to the surprise of many short sellers – therefore, in an attempt to limit their total losses, short sellers bail and begin closing out their positions, i.e. to “cover their shorts.”

The sudden spike in sellers trying to exit their positions by purchasing shares accelerates the upwards momentum of the share price even more, i.e. effectively creating the so-called “short squeeze.”

  1. Short-Seller Collectively Exit Positions → Repurchase Shares @ Current Stock Price
  2. Rising Share Price + Lack of Supply → Accelerated Upward Share Price Movement

Short Squeeze: Risky Stock Market Investing Strategies

Simply put, short selling is a risky strategy – and the general process is described below.

  • Step 1 → The short-seller borrows shares from a brokerage to sell them in the open market under the belief the share price will soon decline.
  • Step 2 → Later on, the short-seller must repurchase the borrowed shares at the current share price to close out their positions.
  • Step 3 → If the share price declines, the short seller can repurchase the shares and profit from the difference between the price at which they were sold (including transaction fees) and the price the shares were bought back – but if the reverse occurs, a short squeeze can transpire.

By continuing to hold their short positions, short-sellers can incur substantial losses — in which the potential downside is theoretically limitless.

Even if the investor remains adamant about being correct on their short thesis, the shares previously sold were borrowed shares, so the shares must eventually be returned to the brokerage firm or institution that originally lent the shares.

Sometimes, as part of the contractual agreement, the broker can place additional pressure (or even force) the short seller to buy the shares and return them.

For certain market participants, a short squeeze can often work in their favor and make their positions generate very profitable returns, but attempting to predict the next short squeeze is a highly risky strategy.

GameStop (NYSE: GME): Short Squeeze Example

GameStop (NYSE: GME), the brick-and-mortar retailer selling video games, gaming merchandise, and consumer electronics, was a prime target for short-sellers.

The short interest on GameStop was in excess of 130% and even peaked over 140% at one point, i.e. the short interest was greater than the actual shares outstanding, a rare sight to see, meaning that many GME shares were “borrowed” multiple times as part of the short selling.

Soon after, a clash between retail investors — with a major role played by the subreddit r/wallstreetbets — and institutional hedge funds ensued.

GME Short Squeeze

GameStop Short Squeeze (Source: S&P Global)

AMC Theaters (NYSE: AMC): Short Squeeze Example

Since then, in the aftermath of the GME saga, more retail investors attempted to anticipate the next upcoming short squeeze by examining the companies that hedge funds were actively shorting.

GME attracted substantial media attention as retail investors celebrated the losses of hedge funds.

The concern here is the seemingly complete detachment of the share prices on these so-called “meme stocks” from their actual fundamentals and recent performance.

For example, AMC Theaters (NYSE: AMC) lost around $4.6 billion in 2020 due to COVID, but its share price benefited from a short squeeze just like GME — moreover, investors still remain optimistic about another short squeeze on the horizon, which has been upholding AMC’s share price as of late.

AMC Short Squeeze

Early 2022 Performance of “Meme Stocks” Basket (Source: Bloomberg)

Ethics of Short Selling: Retail Investors vs. Hedge Funds (HFs)

Hedge funds recently pulled back on their short positions as a precautionary measure, which retail investors again interpreted as yet another victory.

However, the notion that hedge funds are somehow responsible for the downfall of such companies is misguided, to say the least.

In reality, the companies targeted by short-sellers are trading at hampered share prices and have fallen out of favor with the markets for a legitimate reason.

Hence, these underperforming companies possess a high amount of short interest, which typically stems from mismanagement and/or poor corporate decisions.

Of course, certain hedge funds have utilized unethical tactics to cause the share price of companies to decline, but such strategies are rare and not representative of most.

Short Sellers Exposing Fraud: Enron and Luckin Coffee Examples

Despite the negative perception, short selling actually plays a crucial role in the markets regarding reducing volatility and transparency from public companies.

In fact, short-sellers can protect other investors from suffering capital losses by pointing out issues within companies that retail investors could have neglected – contrary to what many assume.

Corporate fraud has frequently been uncovered in public reports published by short-sellers.

  • Enron: Jim Chanos of Kynikos Associates spotted red flags within the financial reports of Enron Corporation and publicly sent out warnings before the company’s fraudulent scheme collapsed.
  • Luckin Coffee: Carson Block of Muddy Water Research publicized an anonymous report produced by Snow Lake Capital in early 2020 that Luckin Coffee was inflating sales and engaging in accounting fraud — after months of denial by management, Luckin eventually admitted $310 million of its revenue were indeed fake, which led to an immediate collapse in share price (and being delisted).

Short selling has gained a negative reputation, especially in recent years, but while a certain minority of short sellers engage in unethical practices, it should be understood that the act of short selling itself is not.

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