If you trade on financial markets, you may have already come across the term “short squeeze”. In this article, we will explain what this term means, how it arises and how it is traded.
Short squeeze, what is it
What does a short squeeze mean? It is a situation where short sellers of a specific security are forced to liquidate their positions due to rapidly rising prices. In most cases, this is a security that was previously widely “shorted” by investors (simply put, this is a short sale where an investor borrows the subject of speculation for a fee and immediately sells it to a third party).
When prices on the financial market rise rapidly, short investors want to close the trade as soon as possible, because they make the most money when asset prices are down. Therefore, if the market rises rapidly, investors can face virtually unlimited losses.
When a large number of investors who speculate that the price of an asset will fall hold a short position, they can quickly get “burned”. It can happen that the price of the asset shoots up. At this point, investors must close their positions to limit their losses. However, this massive closing of positions creates even greater pressure on the price to rise, which can start to go up even faster. In essence, the market has “squeezed” these investors and forced them to buy the assets, thereby driving its price even higher than it was at the beginning. This is the principle of a short squeeze.
What is a short squeeze in stocks, a simple example
The meaning of a short squeeze is easiest to see with round numbers. Imagine you borrow 100 shares of a company trading at $20 and sell them straight away for $2,000. You expect the price to fall to $10, so you could buy the shares back for $1,000 and keep the $1,000 difference.
Instead, the company publishes unexpectedly good news and the price climbs to $30. Buying the shares back now costs $3,000, so you are $1,000 down. Your broker may also ask you to add more money to your account to cover the open position. If many other short sellers are in the same situation, they all start buying at once, and the price may jump to $50. At that point, closing the trade costs you $5,000 and your loss is $3,000, even though you only received $2,000 from the original sale.
The squeeze usually unfolds in a few stages:
- A stock attracts a large number of short sellers who expect it to fall.
- A trigger, such as strong results, takeover rumours or a wave of buying, pushes the price up.
- Short sellers start buying back shares to limit losses or because their broker demands more collateral.
- This buying pushes the price higher, which forces even more short sellers to close their positions.
- Once most shorts have closed, the buying pressure fades and the price often falls back sharply.
What is shorting and how does short selling work?
When shorting, an investor speculates on a fall in the price of the asset. Short selling is based on the investor selling at a higher price so that they can subsequently buy at a lower price, thereby making money. However, investors do not directly own the asset in question. They borrow it and sell it at the current market price. They then wait for the price to fall, buy the same asset at this lower price, and then return it to the lender.
The problem arises when the market does not start to fall, but on the contrary rises even more. In that case, the investor has lost the money they made by selling the borrowed asset, but at the same time they must buy this asset at a higher price in order to return it to the lender. It does not have to be just shares (akcie), you can also short currencies, ETFs or, for example, commodities.
However, there may be more restrictions on shares (akcie) than on other assets. An investor cannot short all shares (akcie). At the same time, the market offers a very limited quantity of shares (akcie) for shorting.
What are the risks of shorting?
Shorting usually carries a higher risk than trading on the long side. If an investor speculates on certain shares (akcie) and their growth, the worst that can happen is that the shares (akcie) fall to 0. The loss is therefore always limited in some way.
In theory, however, the price of companies can rise to infinity, so shorting could also lead to an unlimited loss. An investor should therefore always have a clearly defined strategy and risk management in case the price starts to rise instead of falling.
How to detect a potential short squeeze?
An important question for investors who are interested in or already trade using the shorting style is how to prevent or at least predict a short squeeze. Terms such as Short Interest, Short Interest Ratio or Float are used for this.
Short Interest is the number of assets that have been sold short but have not yet been covered, i.e. the number of assets that are currently short. Thanks to this indicator, it is then possible to estimate to some extent the market situation or the sentiment of individual investors for the given assets. If the Short Interest is high, it means that many traders are very likely focusing on shorting and it is possible that a short squeeze will occur.
Another term associated with predicting a short squeeze is the Short Interest Ratio. This ratio indicates how many of the publicly available assets have been sold in relation to the total number of assets in circulation.
The last term is Float, which expresses the number of assets that the public can freely trade on the market. If we are talking about company shares (akcie), for example, this number varies from company to company and it is up to the company how many shares (akcie) it decides to put into circulation.
If there is a high demand for a limited number of assets on the market, the price of these assets can rise significantly. In this case, demand determines the price of the asset.
What short squeeze stocks tend to have in common
No single figure tells you a squeeze is coming, but stocks that end up squeezed often share several features. You may want to look at all of them together rather than relying on one.
- Days to cover. This compares the number of shares sold short with the average daily trading volume. The more days it would take short sellers to buy back their shares, the harder it is for them to exit quickly.
- Rising borrowing costs. When few shares are left to lend, the fee for borrowing them goes up, which makes holding a short position more expensive.
- A possible catalyst. Upcoming results, product news or regulatory decisions can change sentiment suddenly.
- Strong public attention. Heavy discussion among private investors can bring in a wave of buyers in a short time.
Advantages and disadvantages of shorting
Like everything, shorting has both its advantages and disadvantages. Some people will not find this way of trading suitable, while others swear by it.
Advantages:
- Hedging, short selling allows hedging against financial risks. An investor can short an asset against purchased positions and thus partially reduce risk.
- Speed, asset price increases often take place over the long term and gradually, but a fall can be very rapid and sudden. Therefore, the appreciation of money usually takes place faster than with assets where investors expect growth. On the other hand, a short squeeze can also stop you in your tracks with its speed.
Disadvantages:
- Risk of loss, can be almost unlimited if the investor does not have a properly set strategy and risk management.
- Interest, interest is paid on shorting, which can adversely affect the potential return.
- Dividends, a situation may arise where the investor has to pay out dividends. If dividends are paid during shorting, the investor is obliged to compensate the owner of the borrowed assets to which the dividend belongs.
- Short squeeze, is one of the biggest risks. The market situation can turn very quickly and cost investors a lot of money and forced sales of assets to prevent even greater losses.
Shorting assets, like any other trading on the financial market, involves risks. There is no guaranteed return and we do not recommend it for inexperienced investors. If you are interested in this type of trading, we recommend finding a reliable broker who can advise and assess the investor’s options. You can find more information about short squeezes on this website. If you are interested in trading shares (akcie) on the Czech stock exchange, you can also try looking at our article, which discusses the best Czech shares (akcie).
The GameStop short squeeze
The best known modern example is the GameStop short squeeze of January 2021. The American video game retailer was one of the most heavily shorted stocks on the market, as many professional investors expected its business to keep shrinking. Private investors, many of them organised on the Reddit forum WallStreetBets, noticed how many shares had been sold short and started buying the stock and call options.
The price rose many times over within a few weeks, short sellers rushed to close their positions, and some hedge funds reported large losses. Several brokers temporarily restricted buying of the stock, which caused a public debate in the United States. The price later fell a long way from its peak, so many people who bought near the top also lost money.
Common mistakes during a short squeeze
- Shorting a stock only because it looks overvalued, without checking how crowded the short side already is.
- Holding a losing short position without a stop loss and hoping the price will turn.
- Buying a stock late in a squeeze because the price is rising fast, when the moves can reverse just as quickly.
- Putting a large share of your money into a single speculative trade.
Frequently asked questions about short squeezes
What is a short squeeze?
A short squeeze is a rapid rise in the price of an asset that forces short sellers to buy it back to limit their losses. Their buying adds to demand and pushes the price even higher. It usually happens in assets that many investors have bet against.
What is the meaning of a short squeeze in simple terms?
It means that people betting on a falling price are caught out by a rising price. To stop their losses from growing, they have to buy, and that buying makes the price climb further. The market effectively squeezes them out of their positions.
What happened in the GameStop short squeeze?
In January 2021, private investors bought large amounts of GameStop shares, a stock that was heavily shorted. The price rose sharply in a short time and short sellers, including some hedge funds, suffered large losses while closing their positions. The price later dropped well below its peak.
Can you profit from short squeeze stocks?
Some traders do, but it is very risky because the timing is hard to predict. Prices can rise and fall extremely quickly, and if you buy near the peak you can lose a large part of your investment. If you decide to try it, use only money you can afford to lose and set clear exit rules in advance.