What is a Short Squeeze?
A Short Squeeze occurs when securities with a significant short interest rise sharply in value, which further accelerates the upward price movement from short-sellers closing out their positions.
How a Short Squeeze Works
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 disproportionately 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.”
- Short-Seller Collectively Exit Positions → Repurchase Shares @ Current Stock Price
- 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.