What is a short squeeze?

What is a short squeeze?

A short squeeze can move the stock price faster, often much higher. It can be an exciting event, as traders rush to buy, causing the stock price to go up. Stocks rally, which could lead to more buying as short sellers are forced to “cover” their short positions. Metaphorically speaking, think of a short squeeze as investors rush out of a crowded theater after someone shouts “fire.”

Here’s how the short squeeze works, how it happens and the risks of trading while under pressure.

What is a short squeeze?

Short squeeze occurs when the stock is moving up and short sellers decide to cover their short positions or are forced to do so by way of margin calls. As these short sellers buy the stock, the price goes up, which could create a situation where more shorts have to be covered. This causes the stock to rise more in a vicious circle. In theory, there is no limit to how high a stock can go.

Backstory: In investing, there are two main ways to make money:

  • the purchase: When you buy, you buy shares and you make money when the price goes up. You can sell the stock or hold it and see if it rises further. In general, when people talk about investing, they are talking about going long.
  • Sale: When you make a short position, you borrow the shares from your broker to sell them in the market. Then you try to buy back the stock at a lower price. If you do, you will earn money from the trade. However, if the stock goes up, you will lose money, and if the stock goes up too much, you may have to buy back the stock at a much higher price.

So, when it comes to stress, short sellers decide to buy back the stock, sending it higher. Short presses on a small scale may occur at any time, for example, after the company reports the earrings. The stock may go up when it is ‘buy’, and the higher price hurts the short sellers, so they decide to close their position by buying back the stock, which puts further upward pressure on the stock.

However, in dizzying situations, the value of the stock may rise 10-50 times, sometimes in just a few days. These positions are sometimes called the “mother of all short squeezes” and can be highly profitable for long-term investors and devastating for short sellers. One of the most famous recent examples of short squeeze was the massive rise of GameStop stock in 2021.

How does short compression happen?

Short squeeze can happen for a variety of reasons, but one of the key aspects of the process is the fact that short investors have borrowed money to sell, and therefore must buy it at some point in the future to close the position.

The main elements of a short press include:

  • Margin Borrowing: Short sellers owe money to their brokerage as part of the short selling process, and if the trade goes against them, they will end up with more indebtedness. If their margin loan is too high, the broker will force them to close the position or add more equity (eg cash) to their account to hold the short position.
  • High Short Benefit: Short interest is a measure of the percentage of a company’s outstanding stock that is sold short. The higher the interest on the short, the more volatile the stock, and the more shares that must be bought back later to cover short positions. The short interest per share is usually reported every two weeks.
  • High “days to cover”: Days to Cover is a measure of how quickly short positions close their positions, given the stock’s daily trading volume. The more days that need to be covered, the more stock will fluctuate during stress. For example, if a stock has a short interest of 100 million shares and 2 million shares are traded per day, it will take 50 days to close the short position. In contrast, regular stock may have less than 10 days to cover.
  • Catalyst event: A short press often needs some kind of trigger or trigger. That catalyst could be a good earnings report forcing the market to re-evaluate the company, or it could be a rising stock price that slowly squeezes short positions until suddenly forcing many to race to get out. The trigger ignites forces such as high short interest, days to be covered, and short borrowing in the short squeeze period.
  • Self course: With the stock rising during the stress period, not all investors can close their positions at the same time, especially if the days to be covered are high. They may end up fighting to buy the shares regardless of the price in order to close the position. Then, the investors who initially thought they could weather the crisis may be forced to buy, and as prices rise, more and more investors are tempted or forced to close.

While big stresses get a lot of pressure when they happen, many stocks experience short-term stresses over a typical year as buy and sell trades battle back and forth.

Short term trading risks

Whether you work long or short during a short stress period, your portfolio can be severely damaged during stress due to the following risks:

  • A short squeeze may last for a long time (or not): The short-term stress can be short-term or long-term, and you never know until it’s fully operational. While the stock may rise much higher during the most severe phase of stress, some stocks can remain high above their fair value for years.
  • The short benefit is usually high for good reason: Short sellers are some of the most knowledgeable investors in the market, so the fact that they are short selling stocks should serve as an internal check for investors looking to buy. If the stock has a short-term interest, there is likely a good reason for that. Understand why the shorts are short.
  • You are likely to buy at a very high value: If you are buying in a short squeeze after it rises, you risk buying near the top or at least the local maximum.
  • Possibility of short selling very low: If you are looking to short a stock after it has gone up, you risk that the stock will go up even more and the pressure isn’t over yet. If you are wrong here, you may quickly have to close your position at a loss.
  • Market timing: If you are trying to trade a specific event like a short press, you are trying to time the market and beat other traders. In the short term, anything can happen in the stock market, which means you can make or lose money quickly.

Since short pressures are often driven by technical factors (short sellers covering their positions) rather than fundamentals (strong business performance), it is essential that long-term investors clearly understand the long-term prospects of the company. If the short sellers are wrong and the business is not overvalued or undervalued, the purchase can be very profitable.

Examples of short press

Short factors can capture the imagination of the investing public due to the possibility of getting quick money and the opportunity to participate in the movement of Wall Street. GameStop is one of the most popular short hits in the recent past. The trading action caught the investors (and arguably still is) as the stock remained at a high price for a long time after the immediate short squeeze.

As recently as September 2020, GameStop was trading at less than $2 a share (split-adjusted). It slowly gained momentum through the end of the year and started 2021 at over $4 a share. Many investors thought the company was going bankrupt and invested accordingly. The short seller had a huge position in the stock, and the short interest was greater than the number of shares of stock outstanding. Even relatively modest spikes in the stock can fuel pressure.

And that’s what happened in late January 2021. The stock’s momentum built on itself, and by the end of the month, the stock had soared to over $120 a day — 60 times more in price than previous months. The stock came off that peak but has remained high ever since.

AMC’s theater series stock has also been the subject of a short squeeze, but not as prominently as GameStop. Some have suggested that Tesla has been under pressure for years short, given its high short-term interests and massive overvaluation, compared to the competition.

A short squeeze also features prominently in the plot of the classic movie “Trading Places.” In the movie, the main characters “squeeze” the futures contracts for orange juice commodities.

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Short presses can be exciting, especially if you own the stock before it rockets, although many short presses are relatively modest. However, it is important to understand that no one knows when the short squeeze will end. So, if you decide to try your luck in trading them, then beware.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the performance of past investment products does not guarantee future price increases.

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