What Is A Short Squeeze?
A short squeeze is what happens when many investors with a short position in the same security—meaning they are betting that the price will drop—are forced to cover their positions and buy the security back when the price rises unexpectedly. The resulting demand usually forces the price to rise even higher, exacerbating the situation and the potential losses for short sellers.
Investors who believe a stock, bond or commodity is overpriced can try to profit from that belief by selling it short, in which they sell borrowed securities from their broker and then later buy them back at a hoped-for lower price, pocketing the difference. However, they stand to lose money if the price goes up, meaning they'll have to pay more to buy the securities back than they received when they sold them. Moreover, since prices can go up forever, at least theoretically, a short seller's losses are potentially unlimited.
A short squeeze develops when many investors are short the same security and must scramble to find enough of it in order to buy back and cover their positions. This buying pressure often drives the price even higher, creating even greater losses for the short sellers.
Short squeezes are most common in thinly traded securities as well as those where there is a large short interest, meaning a large number of the securities have been sold short. A high level of short interest is usually a bearish signal.
Profiting From A Short Squeeze
Investors with an opposite view can try to profit from a potential short squeeze. If they see a high level of short interest in a stock, they may conclude that the market is overly pessimistic and that the price is ripe for a rebound, in which case short sellers will be forced to buy back their shares, which may force the price even higher.
The stock price may be depressed for good reasons, so betting on a short squeeze can be just as risky as betting that the price will fall even further. Short squeezes are often temporary, meaning the security's long-term prospects are still not good. In either case, shorting a security or betting on a short squeeze is usually very risky and thus a short-term strategy.
Example Of A Short Squeeze
As an example, let's say that a trader believes ABC Corp. is overpriced at US$25 a share, so he sells short 1,000 shares, realising US$25,000. However, a rumour develops that DEF Inc. may be interested in acquiring ABC, which sends the price of the stock up to US$30 share. Suddenly, the short seller is sitting on a loss of US$5,000.
Rather than wait to find out if the rumour is true or not, he wants to cut his losses and close the position. But other short sellers have the same idea, and all of them start buying shares of ABC before the price goes even higher. That sends the stock up another US$2 a share, to US$32, where the short seller finally buys the shares he needs, absorbing a US$7,000 loss.
Meanwhile, the contrarian thinks ABC is worth more than US$25 a share. Because the short interest is very high, he believes it's a good speculative buy at that price. He too hears the DEF rumour, but assuming that short sellers will need to buy the stock back and will drive the price up even further, he waits to sell his position at US$32, making a quick US$7 per share profit.
A short squeeze develops when many investors with a short position in the same security are forced to cover their positions and buy the security back when the price rises unexpectedly. The resulting demand usually forces the price to rise even higher, aggravating the situation and the potential losses for short sellers.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…