What is a short squeeze and how to trade one
Heard the term "short squeeze" but unsure of its meaning? We examine what a short squeeze is, the risks associated and how to predict when one is happening.
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When a stock price that was previously on a downward trend starts to rise, investors who were betting on the downward trend (or "short selling" the stocks) will scramble to buy the stocks back to prevent or mitigate their losses. This can lead "short squeezers" to jump in and try to make a gain. Find out more about short squeezes, how they work and the risks involved.
What is short selling?
The term "shorting a stock" means betting that the price of a stock will fall. Essentially, you borrow the stocks from a broker and sell them. You now owe your broker as many stocks as you borrowed, so to make money you need the price of the stocks to fall so you can buy them back at a reduced price. We explain more in our short selling guide.
The issue is, that the value of those stocks might rise instead. If they do, then you need to spend more money on them to buy them back than you initially sold them for, which means you make a loss. Potentially, the stock value could rise infinitely and you could find yourself losing a lot more money than you originally invested.
When prices rise, a short seller usually cuts their losses and buys the stock for the increased price. However, it can be difficult to do since everyone else who shorted that stock is also trying to buy back them back. In the period between choosing to buy and actually buying, that stock could have risen a great deal more.
The panic buying then pushes the price of the stock higher. The broker gets a fee from the short seller whether the price rises or falls.
What is a short squeeze
There are three main terms investors need to understand when it comes to a short squeeze:
1. Short sellers- As defined above a short-seller is someone who bets against the share
2. Shorters- Just another way of describing short-sellers
3. Short Squeezer - Investors who force the short-sellers to buy the stock (go long on it)
In simple terms, a short squeeze is when shorters (people who are shorting a stock) are "squeezed" out of their positions because of a rapid rise in the stocks they are shorting.
This happens when a price that is expected to fall actually rises meaning the short sellers need to act fast to limit their losses.
Short sellers are only loaning shares and making money between the difference of the price they can get the shares and the price it falls to.
Should the price go up they may be forced to buy at a higher price and pay the difference between the price set and its sale price.
Sometimes, daredevil investors use this as an opportunity to make money by buying stocks while shorters scramble to buy back stocks and sell at the peak.
While opportunistic, it comes with a lot of risk.
After all, investors performing a short squeeze are not necessarily trading on fundamentals of a company.
Instead, it's a pure supply and demand equation with the short squeezer profiting if demand for what they hold remains high.
However, if they don't time it correctly, they still need to be able to get out of your position. The short squeezer could be left with a rapidly falling stock.
Worse still, they could buy at the peak only to see everyone else sell and the investor has overpaid for a stock that is now falling rapidly.
How does a short squeeze happen
A short squeeze generally follows a similar pattern:
- A group of short sellers identify a stock that they believe is overvalued. They go to the market and look to borrow the shares from owners in anticipation that the stock will fall.
- However, the price of the stock increases. This can be for a number of legitimate reasons including stronger than expected announcements, or it can just be because of a short squeeze.
- The short seller, who has unlimited risk, is forced into buying to offset the losses of the current short sell. After all if an investor buys a share and it goes to zero they lose 100% of its value. But, A short seller can lose almost an infinite amount of money should the share continue to rise.
- This leads to a value trap for the short sellers. As they all pile in, supply and demand kicks in meaning the price of the stock continues to rise.
- At this point those first in on the short-squeeze see a rise. They are likely to get out causing a temporary dip in share price.
- More often than not investors get a second spike in price over the coming days. Although it is unknown until after the short has happened whether or not a second bounce in price will occur.
- The short squeeze is over and the price falls to a relatively normal price.
Famous examples of short squeezes
GameStop short squeeze
Beginning with GameStop (GME), a group of retail investors on Reddit intended to drive up the price of stocks that were being heavily shorted by hedge fund managers in January 2021. This led to a significant rise in the stock price and a number of short sellers making substantial losses. These price movements led to stock volatility and trading platform outages.
The price movements weren't as a result of company news or any fundamental financial factors, which are a more sound basis for making investment decisions.
Volkswagen short squeeze
In 2008 there was a short squeeze on Volkswagen. In already uncertain times, a lot of investors were shorting Volkswagen stocks, but it very briefly surged, when Volkswagen reported several quarters of earnings that came out better than it expected. For several months after, the stock saw a fair bit of volatility on a generally downward trend.
How to predict a short squeeze
This is usually done with some advanced charting that more complex and professional trading platforms offer. You'll need to make use of moving average tools such as "Bollinger Bands" to find out whether the stock price is above or below the moving average. You can also calculate the short interest percentage and the short interest ratio. Your trading provider should have all the information you need for these.
Daily moving averages can give you an idea of how the stock has traded in the last few months more smoothly than by looking at the price movements alone. You can use simple moving averages (SMA) to compare short term moving averages (20 to 50 days) with longer term moving averages (200 or so days).
Short interest percentage
This is a percentage of how many of a stock's shares are shorted. It's calculated by dividing the number of shorted shares by the number of outstanding shares.
So, if a company has 500,000 shares outstanding and 50,000 of them are being shorted then the short interest percentage is 10%. The higher the percentage, the more short sellers there are for that stock. This means that there will be more short sellers battling to sell their shares if the price starts to rise.
Short interest ratio
The short interest ratio is the number of shares that are currently being shorted divided by the stock's average daily trading volume, which is the average number of shares that are traded each day in that stock.
The interest ratio gives an estimate of how long it might take for short sellers to be able to buy back their shares if they were to rise in price. The higher the short interest ratio the more likely it is that short sellers will panic and a short squeezer can take advantage.
What happens after a short squeeze?
After a short squeeze there tends to be a period of volatility, potentially for several months.
It can be tempting to give a short squeeze a go, but it can be really high risk, and you need to make sure that you sell the stocks you've bought before they start to fall again. It could be worth giving it a go with a demo account, such as with eToro or IG. Once you think you've got your head around it and want to try it with real money, start small and make sure you understand the risks.
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