Understanding Short Squeezes
Before you can understand short squeezes, you have to understand how short selling works.
If a short seller thinks a stock is overvalued and shares are likely to drop in price, they can borrow the stock through a margin account. The short seller will then sell the stock and hold onto the proceeds in the margin account as collateral. Eventually, the seller will have to buy back shares. If the stock's price has dropped, the short seller makes money due to the the difference between the price of the stock sold on margin and the reduced stock price paid later. However, if the price goes up, the buyback price could rise beyond the original sale price, and the short seller will have to sell it quickly to avoid even greater losses.
What is a short squeeze?
A short squeeze occurs when many investors short a stock, or bet that its price will go down, and the stock's price shoots up instead.
Let's say an investor believes that shares of NoGood Co. are overvalued at their current share price of $100, then that investor can borrow someone else's shares of NoGood and immediately sell them to another buyer -- again, for $100. Of course, you can't simply sell what you don't own with no consequences -- at some point, those borrowed shares have to be returned. When that day comes, the investor needs to buy shares in the market to be able to return them to the lender. If the investor is correct and the share price has indeed declined, let's say to $70, then the investor will make $30 in profit. They sold borrowed shares for $100, repurchased them for $70, returned the shares, and pocketed the difference.
If the shares of NoGood instead increase in price, then the short seller is at risk of losing a very large amount of money on the trade. (Unlike price declines, which are capped when the share price reaches $0, price hikes are theoretically limitless.) If a stock's price rises quickly, then short sellers sometimes scramble to close out their positions as rapidly as possible. A high volume of investors who are shorting a stock and racing to exit their positions at the same time creates a short squeeze. The sudden surge in demand to buy shares of a stock can send the stock's price even higher.
If, for example, NoGood Co. reported better-than-expected earnings and its stock price jumped to $120, then panicked short-sellers might rush to close out their positions before the share price kept climbing. This sudden high demand could cause the stock's price to rise even more sharply to $130 or $140 per share. The dramatic jump in price "squeezes" those who shorted the stock.
Why Short Squeezes Happen
As noted, short-sellers open positions on stocks that they believe will decline in price. However sound their reasoning is, it can be upen
ded by a positive news story, a product announcement, or an earnings beat that excites the interest of buyers.
The turnaround in the stock’s fortunes may prove to be temporary. But if it's not, the short seller can face runaway losses as the expiration date on their positions approaches. They generally opt to sell out immediately even if it means taking a substantial loss.
That's where the short squeeze comes in. Every buying transaction by a short-seller sends the price higher, forcing another short-seller to buy.
Risks of Trading Short Squeezes
There are many examples of stocks that moved higher after they had a heavy short interest. But there are also many stocks that are heavily shorted and keep falling in price.
A heavy short interest does not mean the price will rise. It means that many people believe it will fall. Anyone who buys in the hopes of a short squeeze should have other, and better, reasons to think that the price of the stock will go higher.