Glossary   »   S   »  Short Squeeze
published-date Published: January 7, 2024
update-date Last Update: January 30, 2024

Short Squeeze

Short selling aims to profit from a stock’s decline in value. This strategy involves borrowing a security from your brokerage, which you believe will decrease in price, and selling it on the open market. The goal is to buy the same stock back later at a lower price than what you sold it for. The difference, minus the repayment of the initial loan, is your profit.

However, short selling carries significant risks. One major risk is a short squeeze. This can happen if positive news, strong earnings, or other bullish factors drive the stock price higher. When this occurs, short sellers may rush to buy back the stock to cover their positions and limit losses. This rush of buying can further drive up the stock price, leading to a rapid and sharp increase in its value. This phenomenon, where the stock moves sharply higher due to short sellers covering their positions, is what’s known as a short squeeze.

Understanding the Short squeeze

A short squeeze is particularly dangerous because, unlike buying a stock, where the worst-case scenario is the stock value dropping to zero, short selling has theoretically unlimited downside. When you short a stock, you’re betting on its decline. If the stock price instead skyrockets, your potential losses can exceed your original investment, continuing to grow as the stock price rises.

Key indicators of a short squeeze include:

  1. High Short Interest: A large number of traders have shorted the stock, expecting its price to fall. If the stock price unexpectedly surges, these short sellers are pressured to close their positions to avoid further losses, contributing to the stock’s upward momentum.
  2. Narrative Shift: A compelling story develops that disconnects the stock’s price from its fundamental value, sometimes based on growth potential or financial stress.
  3. Leveraged Trading: Traders on both sides of the market, some betting on growth and others on decline, often use options and other leveraged instruments, increasing the potential for volatility.

Historical examples like GameStop (GME) in 2021 and Tesla (TSLA) in 2020 displayed classic short squeeze traits. Short sellers were forced to cover their positions due to large losses or the unavailability of shares to borrow. In 2022, companies like Bed, Bath & Beyond (BBBY) and Carvana (CVNA) faced similar situations, and in early 2023, heavily shorted firms included Coinbase Global (COIN) and Occidental Petroleum (OXY).

When a stock’s price soars suddenly, it’s crucial to ask who’s buying at such high levels. Often, it’s short sellers who can no longer afford to maintain their positions or who have reached their pain threshold, driving the price even higher as they scramble to cover their shorts.

Be careful on the way

If you’re a long-term investor holding a stock that’s undergoing a short squeeze, it’s generally not advisable to make hasty trades. Remember the principles and goals that have guided your investing journey. If investing in a stock caught in a squeeze doesn’t align with your long-term strategy, it might be wise to refrain from trading. Should you choose to engage, be fully aware of the risks. Stocks in the midst of a short squeeze carry significant risk.

Recognizing a short squeeze is much easier retrospectively. The challenge lies in identifying conditions that might lead to a squeeze before it happens, and then deciding how, or if, you should respond.

Short selling a stock is complex. It involves borrowing the stock (and paying interest to the lender), then selling it. Finding shares to borrow can be difficult due to high demand or limited availability.

To measure a short squeeze, one key metric is the short interest ratio or “days to cover.” This calculates the time it would take to buy back all the shorted shares. It’s found by dividing the total number of shorted shares by the average daily trading volume. A higher “days to cover” number indicates a more significant potential impact.

Another metric is “short interest as a percentage of float.” This shows the proportion of short-sold shares compared to the total shares available for public trading. While most stocks have a small short interest, often in single digits, a higher percentage can signal strong bearish sentiment. A short interest of 10% or more of the float can be a red flag.

How to identify a squeeze?

Certain factors enhance the likelihood of a short squeeze. These factors, when combined, can significantly increase the chances of one occurring:

  1. An asset trading near its 52-week lows, with its current price substantially lower than its estimated fair value. There may be various reasons for this discrepancy, but markets often adjust to reflect fair value eventually. This adjusted value can act as a baseline for the potential short squeeze price.
  2. Savvy traders often track assets with a Short Interest (SI) above 20%, but they pay particular attention to those with an SI exceeding 50%—especially if their analysis suggests the market hasn’t fully recognized the asset’s positive attributes.
  3. Monitoring the borrowing costs of assets is also crucial. A noticeable decrease in these costs coupled with a rise in asset prices might signal that a major short seller is starting to cover losses, potentially leading to panic and a squeeze.
  4. Company announcements, such as general meetings, product launches, or other significant news, can act as triggers for price movements. Staying informed about such events is key when anticipating a potential short squeeze.

Consider the fundamentals

When considering buying a stock amid a short squeeze, especially one trading at high levels, it’s crucial to explore reasons beyond the squeeze for why the stock might be rising.

First, assess the stock’s fundamentals. Ask yourself if there are compelling reasons to own the stock, and whether your interest is driven by the market trend or solid financial analysis. Always do thorough research and be cautious about investing too heavily in one stock. A stock in a short squeeze could continue to climb, but if its fundamentals don’t justify higher prices, it might be wise to look for other investment opportunities.

Take Tesla (TSLA) in 2020 as an example. The company’s short squeeze was supported by positive fundamentals, including consistent profitability and the anticipation of being included in the S&P 500 Index (SPX). This resulted in a significant increase in its share price, followed by a drop of nearly 60%. However, Tesla rebounded, underwent a stock split, and was indeed added to the SPX, showing that a short squeeze can have a favorable outcome if backed by strong fundamentals. On the other hand, other stocks involved in short squeezes haven’t always performed well, often due to a lack of fundamental support.

Playing the squeeze on the long side

If you’re considering trading a stock during a potential short squeeze, buying a stock with high short interest to capitalize on the possible upside of the squeeze—keep these points in mind:

  1. Understand and Manage Risk: It’s vital to recognize the risks involved and have strategies to control them. Regardless of the size of your trades, always manage your risk exposure. Set a clear limit on how much money you’re willing to lose on any trade before you enter it.
  2. Expect Uncertainty in Price and Timing: When a stock is in the midst of a short squeeze, its price trajectory can be unpredictable. Analysts often anticipate a market correction post-squeeze, but predicting the final price point and timing is challenging. The stock might not correct as expected, or it might take longer than anticipated.
  3. Be Cautious with Weak Fundamentals: If a stock’s surge is not supported by strong fundamentals or significant positive changes in the company, exercise caution. Such upward movement can be unstable. If the market runs out of new buyers willing to pay increasingly higher prices, the stock’s value could plummet quickly. Always analyze the underlying reasons for the stock’s movement and be wary of investing based solely on momentum.

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