A short squeeze can drive a stock’s price up rapidly, often significantly. It occurs when traders rush to buy shares, causing the stock price to surge as they try to cover their short positions. This frenzy can lead to even higher prices, as short sellers are compelled to buy back shares at escalating costs. Imagine a short squeeze as a chaotic scramble to exit a crowded theater after someone shouts “fire.”

Here’s a breakdown of how a short squeeze functions, what triggers it, and the risks associated with trading during such a surge.

What is a short squeeze?

A short squeeze happens when a stock’s price rises, prompting short sellers to cover their positions either voluntarily or due to margin calls. As these short sellers buy back shares, the price continues to climb, which can force even more short sellers to cover, creating a feedback loop that drives the stock even higher. In theory, there’s no upper limit to how high the stock can go.

Here’s a brief overview of the concepts involved:

Going Long: This involves buying a stock with the expectation that its price will increase. Investors make money by selling the stock at a higher price or holding it if they believe it will rise further. This is the most common approach to investing.

Going Short: In this strategy, you borrow shares from a broker and sell them, hoping to buy them back at a lower price. If the stock price goes up, however, you face losses, and if it rises significantly, you may have to repurchase the shares at a much higher price.

During a short squeeze, short sellers buying back shares drive the price up further. Smaller short squeezes can occur after events like earnings reports, where the stock price rises due to buying by long investors and forces short sellers to cover, pushing the price up more.

In dramatic cases, a short squeeze can cause a stock’s price to skyrocket 10 to 50 times its original value within days. Such extreme events are known as the “mother of all short squeezes” and can be highly profitable for long investors while devastating for short sellers. A notable recent example is the GameStop short squeeze in 2021, which saw the stock’s price surge dramatically, and it experienced another significant rise in May 2024 following a social media post related to the meme stock phenomenon.

How a short squeeze happens

A short squeeze can arise from several factors, but a key element is that short sellers have borrowed shares and must eventually repurchase them to close their positions. Here’s an overview of the critical components of a short squeeze:

Borrowing on Margin: Short sellers borrow shares from their brokerage to sell them, and if the stock price moves against them, they may incur significant losses. If their margin loan exceeds a certain threshold, the broker may require them to either close the position or add more cash to their account to maintain the short sale.

High Short Interest: This refers to the percentage of a company’s outstanding shares that are currently sold short. A high short interest indicates that a substantial number of shares need to be repurchased, which can lead to increased volatility. Short interest is usually updated every two weeks.

High Days to Cover: This metric shows how long it would take for short sellers to cover their positions based on the stock’s daily trading volume. A higher number of days to cover means that it will take longer to close out short positions, contributing to volatility during a squeeze. For instance, if a stock with 100 million shares sold short trades 2 million shares a day, it would take 50 days to cover the short positions.

Trigger Event: A short squeeze often requires a catalyst to initiate it. This could be a positive earnings report that causes a reassessment of the company’s value or a rising stock price that forces short sellers to cover their positions. The trigger amplifies factors such as high short interest and high days to cover, setting off the squeeze.

Self-Perpetuating Cycle: As the stock price rises, short sellers scramble to buy shares to cover their positions, especially if the days to cover is high. This demand drives the price up further, creating a cycle where more short sellers are forced to buy, which continues to push the stock price higher.

While major short squeezes often make headlines, many stocks experience shorter, less dramatic squeezes throughout the year as long and short investors compete.

Risks of trading in a short squeeze

Whether you’re trading long or short during a short squeeze, your portfolio can face significant risks:

Uncertainty of Duration: A short squeeze may be brief or last for an extended period, and its duration is unpredictable. While a stock may surge dramatically during a squeeze, some stocks can remain overvalued for extended periods, potentially years.

Reason for High Short Interest: Short sellers are typically well-informed investors. High short interest often indicates underlying issues with the stock. It’s important to understand why a stock has high short interest before making investment decisions.

Risk of Buying Too High: If you buy into a short squeeze after the stock has surged, you may be purchasing near the peak or a local maximum, increasing the risk of buying at an inflated price.

Risk of Short Selling Too Low: If you short sell a stock after it has already risen significantly, there’s a risk that the stock could climb even higher if the squeeze isn’t over. This could force you to cover your position at a loss.

Market Timing Challenges: Trading during a short squeeze involves trying to time the market and predict movements, which can be highly unpredictable. This can lead to rapid gains or losses.

Technical vs. Fundamental Factors: Short squeezes are often driven by technical factors like short sellers covering their positions, rather than fundamental improvements in the business. It’s crucial for long investors to evaluate the long-term prospects of the company to determine if it’s genuinely undervalued or if the high short interest is justified.

Examples of short squeezes

Short squeezes often capture the public’s imagination due to the potential for rapid gains and the excitement of participating in high-stakes Wall Street action. One of the most notable recent examples is GameStop, which became a media sensation during its short squeeze and continues to trade at elevated levels long after the initial frenzy.

In September 2020, GameStop shares were trading for less than $2 each (adjusted for splits). By the end of the year, the price had risen to over $4 per share, but many investors believed the company was on the brink of failure and bet against the stock. A significant short seller had a large position, with short interest exceeding the number of shares available. Even modest increases in the stock price could trigger a squeeze.

This scenario unfolded dramatically in late January 2021. The stock’s momentum accelerated, reaching an intraday high of over $120 by the end of the month—an increase of approximately 60 times its price from just a few months earlier. Although the stock has since retreated from its peak, it remains elevated.

The theater chain AMC also experienced a short squeeze, though it didn’t attract as much attention as GameStop. Additionally, some argue that Tesla has been under a prolonged short squeeze due to its high short interest and perceived overvaluation compared to its competitors.

Short squeezes are also featured in the classic film “Trading Places,” where the main characters manipulate orange juice commodity futures in a dramatic squeeze.

In Conclusion

Short squeezes can be thrilling, particularly if you’re holding the stock before it skyrockets. However, many short squeezes are more subdued in their impact. It’s crucial to remember that predicting the end of a short squeeze is challenging. If you choose to engage in trading during these events, proceed with caution.