Short Squeeze

What is a 'Short Squeeze'

A situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock. A short squeeze implies that short sellers are being squeezed out of their short positions, usually at a loss. A short squeeze is generally triggered by a positive development that suggests the stock may be embarking on a turnaround. Although the turnaround in the stock’s fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out even if it means taking a substantial loss.

BREAKING DOWN 'Short Squeeze'

If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if a stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price is pushed even higher.

Two measures useful in identifying stocks at risk of a short squeeze are (a) short interest and (b) short-interest ratio. Short interest refers to the total number of shares sold short as a percentage of total shares outstanding, while short-interest ratio (SIR) is the total number of shares sold short divided by the stock’s average daily trading volume.

As an example, consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials as a treatment for skin cancer. There is considerable skepticism among investors about whether this drug candidate will actually work, and as a result, 5 million Medico shares have been sold short of its 25 million shares outstanding. Short interest on Medico is therefore 20%, and with daily trading volume averaging 1 million shares, the SIR is 5. The SIR means that it would take 5 days for short sellers to buy back all Medico shares that have been sold short.

Assume that because of the huge short interest, Medico had declined from $15 a few months ago to $5 shortly before release of the clinical trial results. When the results are announced, they indicate that Medico’s drug candidate works better than expected as a treatment for skin cancer. Medico’s shares will “gap up” on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions. A short squeeze in Medico is now on, and can drive it much higher due to massive buying pressure.

Contrarian investors look for stocks with heavy short interest specifically because of a short-squeeze risk. These investors may accumulate long positions in a heavily shorted stock if they believe its chances of success are significantly higher than believed by those who are bearish on it. The risk-reward payoff for a heavily shorted stock trading in the low single digits is quite favorable for contrarian investors with long positions. Their risk is limited to the price paid for it, while the profit potential is unlimited. This is diametrically opposite to the risk-reward profile of the short seller, who bears the risk of theoretically unlimited losses if the stock spikes higher on a short squeeze.

RELATED TERMS
  1. Short Covering

    Buying back borrowed securities in order to close an open short ...
  2. Weak Shorts

    Traders or investors who hold a short position in a stock or ...
  3. Short Interest

    The quantity of stock shares that investors have sold short but ...
  4. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  5. Short Market Value

    The market value of securities sold short through an individual's ...
  6. Long Squeeze

    A long squeeze, which involves a single stock, occurs when a ...
Related Articles
  1. Stock Analysis

    Watch The Short Sellers

    The recent strong upward move in the market may have been caused by short sellers covering their positions. Investors should watch for short squeeze opportunities when trading.
  2. Investing

    Short Selling Analytics

    One issue with data on short selling is that it is not real-time in nature, unlike most other market data. Most major exchanges such as the New York Stock Exchange, Nasdaq, and the Toronto Stock ...
  3. Trading Strategies

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  4. Active Trading Fundamentals

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  5. Active Trading Fundamentals

    Guide to Short Selling

    Want to profit on declining stocks? This trading strategy does just that.
  6. Term

    Understanding Short Covering

    Short covering is buying back borrowed securities to close an open short position.
  7. Stock Analysis

    The 5 Most Shorted NYSE Stocks (VALE, CHK)

    Understand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.
  8. Trading Strategies

    Rules and Strategies For Profitable Short Selling

    Short sales work well in bull and bear markets but strict entry and risk management rules are required to overcome the threat of short squeezes.
  9. Fundamental Analysis

    Short Sales For Market Downturns

    This strategy can help in market downturns, but it's not for inexperienced traders.
  10. Investing Basics

    Difference Between Short Selling And Put Options

    Short selling and put options are essentially bearish strategies used to speculate on a potential decline in a security or index, or to hedge downside risk in a portfolio or specific stock.
RELATED FAQS
  1. What is the difference between a short squeeze and short covering?

    Learn about short covering and short squeezes, the difference them and what causes short squeezes. Read Answer >>
  2. What is the difference between a short squeeze and a long squeeze?

    Learn about short long squeezes, the difference between short and long squeezes, and how investors and traders can be squeezed ... Read Answer >>
  3. How does holding period return yield differ between short and long positions in the ...

    Learn how holding period return yields differ from short and long positions due to a number of factors and shorting comes ... Read Answer >>
  4. When short selling, how long should you hold on to a short?

    Explore the reasons for short selling and the various factors that influence how long an investor may wish to maintain a ... Read Answer >>
  5. Please explain what a short seller is on the hook for when he or she shorts a stock ...

    Short selling is hard enough to get your head around without getting into all the particulars. If you have a basic understanding ... Read Answer >>
  6. How long can a trader keep a short position?

    Learn whether there are any limitations on how long may an investor hold a short position, and explore the costs associated ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center