Financial Literacy

What Is a Short Squeeze and How Does It Work?

What is a short squeeze? If you, like many investors, saw what happened with GameStop (NYSE: GME), you likely have this question. After all, it’s not a strategy often used by the common investor. Here, we’ll answer your question. But before we talk about short squeezes, there’s something you need to understand: short selling.

What is a short squeeze? It's when investors borrow stock, expecting prices to fall. Instead, prices increase, creating a buying frenzy.

The Lesson Behind Short Squeezes: Short Selling

Short selling is the idea behind a short squeeze. It is an advanced trading strategy. Short selling starts when investors think the price of a stock will go down. So they borrow shares and sell them at the current price. Once the price of shares drops, the investor will buy the shares back and return them to the lender.

There are two parts to short selling: selling to open and buying to close. Your short position opens at the sale of the stock and closes when you buy the security back. Another way to think about this is as the reverse of a normal investment – you’re selling the security first and then hoping to buy it back at a cheaper price.

Here’s an example: A company’s stock is trading at $20 a share. You think the price will drop, so you borrow 100 shares. You then sell them for $2,000. Here are two potential outcomes:

Gain: The price falls to $10 a share. You buy the shares back to return to the lender. You spend $1,000 to buy back 100 shares. Overall, you made a gain of $1,000 ($2,000 – $1,000 = $1,000).

Loss: The company releases a great earnings report, and the stock starts to rise. You buy back 100 shares as quickly as you can, but the stock is worth $25 when you do. You buy back the shares for $2,500 to return to the lender. Overall, you saw a loss of $500 ($2,000 – $2,500 = -$500).

Another reason to short sell is hedging. This is when an investment is made to help reduce risk in price movements. Short selling is risky business. Because of that, it’s a strategy used mostly by hedge funds (hence the name).

Now that we have an understanding of short selling, let’s answer your question: What is a short squeeze?

What Is a Short Squeeze?

A short squeeze comes from a crowded short trade. This means there are a large number of short sellers on a certain stock. And that means there’s a lot of risk.

A short squeeze happens when the price goes up. This can be caused by anything: positive revenue reports, a new acquisition or a new product line. Whatever it may be pushing prices higher, short sellers might need to buy quickly. They start buying shares back to cover their losses, and other short sellers will start to do the same. This causes the price to increase as demand increases.

Often, but not always, a short squeeze is started by people who know the situation. These could be individual investors or investors in a large hedge fund. Either way, someone is going to profit and someone is going to lose. And although there aren’t many real-life examples, they do happen.

Real-Life Short Squeeze Examples

One example bringing attention to short squeezes is GameStop. The most recent big squeeze, it has average investors looking into this (sometimes) profit-producing strategy. So what happened with GameStop stock?

Robinhood is a newer trading app. It allows everyday investors to participate in the market. And Reddit is a social media platform used by people who want to talk about similar interests. That includes investing. Retail investors gathered on Reddit and discovered hedge funds were shorting GameStop stock. So the people rallied together and began buying all the shares they could, whether it was on Robinhood or through their portfolio manager. And increased demand caused an increase in price. This forced short sellers to frantically buy back GameStop stock, raising the price even more.

But this wasn’t the first time the market saw a short squeeze. And it likely won’t be the last. Back in 2008, in the middle of the financial crisis, Volkswagen’s stock was short squeezed. After an attempted takeover by Porsche, the company’s stock increased from €210.85 to €1,000. This happened over two days. Porsche’s CEO at the time was charged with market manipulation.

But how do investors know which companies to short squeeze?

Short Interest

Short interest is one of the factors leading to a short squeeze. It’s the number of shares sold short but not yet covered or closed. Short interest is often expressed as a percentage of the stock’s float. A stock’s float is the number of shares available to trade. So if there are 100 million shares floating and 50 million shares sold short, short interest is 50%.

A stock’s short interest is usually updated at the end of the month. Although “normal” short interest may vary by company and even industry, double digits usually means investors are pessimistic. These companies are ideal targets for a short squeeze.

We hope this answered your question of “What is a short squeeze?” If it did, then consider signing up for our free Investment U e-letter below. It’s packed with tips and tricks from our investing experts. No matter what level of investing you’re at, there’s something in Investment U for everyone.

To read more about the recent GameStop short squeeze, check out our article “Robinhood Blocked Gamestop Trading: Is This The End?”

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