A short trade can cause a stock price to rise rapidly, often much higher. it can be an exciting event, as traders rush to buy, driving up the price of a stock. stocks soar, which could lead to even more buying as short sellers are forced to “hedge” their shorts. Metaphorically, think of a little shake as investors rushing out of a crowded theater after someone yells “fire.”
This is how a short works, how it happens and the risks of trading during a tightening.
what is a short squeeze?
A short squeeze occurs when a stock rises and short sellers decide to cover their short positions or are forced to do so through margin calls. As these short sellers buy the stock, the price rises, potentially creating a situation where more shorts must be covered. this causes stocks to skyrocket further in a vicious circle. In theory, there is no limit to how much a stock can go up.
The backstory: When investing, there are two main ways to make money:
- going long: when you go long, you buy stocks and make money when they rise in price. you can either sell the stock or wait and see if it goes higher. In general, when people talk about investing, they mean going long.
- Going Short: When you go short, you borrow shares from your broker to sell them on the market. then try to buy back the shares at a lower price. if you do, you will make money on the trade. however, if the stock goes up, you will lose money, and if the stock goes too high, you may be forced to buy back the stock at a much higher price.
so when it comes to a squeeze, the short sellers decide to buy back the stock, sending it higher. Small-scale short squeezes can happen at any time, for example after a company reports earrings. the stock can rise as “longs” buy it, and the higher price hurts short sellers, so they decide to close their position by buying the stock back, putting further upward pressure on the stock.
However, in spectacular situations, the value of shares can increase between 10 and 50 times, sometimes in a few days. These situations are sometimes called the “mother of all short squeezes” and can be tremendously lucrative for long investors and ruinous for short sellers. One of the most famous recent examples of a short was the massive surge in gamestop stock in 2021.
how a short squeeze happens
A short call can occur for a variety of reasons, but a key aspect of the process is the fact that short investors have borrowed money to go short and therefore must buy it at some point in the future to close the position.
key elements of a brief handshake include:
- margin lending: Short sellers owe money to their brokerage as part of the short selling process, and if a trade goes against them, they will end up owing even more. if your margin loan gets too high, the broker will force them to close the position or add more capital (eg cash) to your account to hold the short position.
- high “short interest” : Short interest is a measure of the percentage of a company’s outstanding shares that are being sold short. The higher the short interest, the more volatile a stock can be and the more shares will have to be bought back later to cover short positions. short interest on a stock is typically reported every two weeks.
- high “days to cover”: days to cover is a measure of how quickly shorts could close their positions, given the value of a share. daily trading volume. the higher the days to cover, the more volatile a stock will be during a downturn. For example, if a stock is short 100 million shares and trades 2 million shares per day, it would take 50 days to close the short position. conversely, a normal stock may have less than 10 days to cover.
- a “trigger” event: often a short rally needs some sort of catalyst or trigger. That trigger could be a good earnings report that forces the market to reassess the company, or it could be a rise in the stock price that slowly puts pressure on shorts until it suddenly forces many to run for the exits. the trigger ignites forces such as high short interest, high days to cover, and the borrowing of shorts in the short crunch.
- a self-perpetuating cycle: as As the stock rises during a squeeze, not all investors can close their positions at the same time, especially if days to cover are high. they may end up fighting to buy shares regardless of the price to close the position. then investors who at first thought they could withstand the pressure may be forced to buy, and as the price rises, more and more investors are tipped or forced to close.
While high-profile shocks get a lot of press attention when they occur, many stocks experience short-lived contractions throughout a typical year, as longs and shorts battle back and forth.
risks of trading in the short term
Whether you go long or short during a short crunch, your portfolio can be severely affected during a crunch by the following risks:
- the brief squeeze can go on for a long time (or not): a brief squeeze can be short-lived or long-lasting, and you’ll never know until it’s fully developed. while a stock can go much higher during the sharpest phase of the downturn, some stocks can stay high above their fair value for years.
- short-term interest is often high because for good reason: short sellers are some of the best-informed investors in the market, so the fact that they are short should be a test for investors looking to go long. If a stock has high short-term interest, there’s probably a good reason for it. understand why shorts are short.
- Possibility of you buying too high: If you are buying on a short position after it has broken out, you risk buying close to the top or at least a local high.
- Chance You’ll Short Too Low: If you’re looking to short a stock after it’s spiked, you run the risk of that the stock could rise further and that the pressure is not over yet. if you’re wrong here, you may need to quickly close your position at a loss.
- Market Timing: If you’re trying to trade a specific event, such as a short crunch, you’re trying to time the market and get ahead of other traders. In the short term, anything can happen in the stock market, which means you can make or lose money quickly.
Because short pressures are often driven by technical factors (short sellers hedging their positions) rather than fundamental factors (strong business performance), it is vital that long investors clearly understand the long-term outlook of the business. If the short sellers are wrong and the business is not overvalued or impaired, going long could be very profitable.
examples of short squeezes
Short contracts can capture the imagination of the investing public due to the potential for quick cash and the opportunity to get in on the action on Wall Street. gamestop is one of the most high-profile short squeezes of the recent past. The trading action caught investors (and arguably still does) as shares remain high long after the immediate contraction.
Recently in September 2020, gamestop traded for less than $2 per share (adjusted for division). it slowly gained momentum through the end of the year and started 2021 at over $4 a share. many investors thought the company was going bankrupt and invested accordingly. a short seller had a huge position in the stock, and the short interest was greater than the number of shares outstanding. even relatively modest gains in stocks could spark a contraction.
And that’s what happened at the end of January 2021. The momentum in the stock picked up and by the end of the month, the stock had soared to over $120 intraday, some 60x more than a few months earlier. . the stock came off that peak, but has remained elevated ever since.
shares in cinema chain amc have also been subject to a reduction, although not as prominently as gamestop. Some have suggested that Tesla has been subject to a short constraint for years, given its high short interest and massive overvaluation, relative to the competition.
a little squeeze also figures prominently in the plot of the classic movie “swapping places”. In the film, the main characters “squeeze” orange juice commodity futures.
Shorting can be exciting, especially if you own the stock before it skyrockets, although many shorts are relatively modest. Still, it’s important to understand that no one knows when a little squeeze will end. so if you decide to try your luck trading them, be careful.
Editorial Disclaimer: All investors are advised to conduct their own independent research on investment strategies before making an investment decision. furthermore, investors are cautioned that past performance of the investment product is not a guarantee of future price appreciation.