Short Squeeze

AAA

DEFINITION of '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.

INVESTOPEDIA EXPLAINS '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. Gap

    A break between prices on a chart that occurs when the price ...
  4. Days To Cover

    A measurement of a company's issued shares that are currently ...
  5. Buy To Cover

    A buy order made on a stock or other listed security that closes ...
  6. Short Interest

    The quantity of stock shares that investors have sold short but ...
Related Articles
  1. Active Trading Fundamentals

    Short Selling: Making The Ban

  2. Active Trading Fundamentals

    The Short Squeeze Method

  3. Options & Futures

    Bear Put Spreads: A Roaring Alternative ...

  4. Options & Futures

    The Truth About Naked Short Selling

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Conduit Issuer

    An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects ...
  3. Financing Entity

    The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed ...
  4. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  5. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
  6. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option ...
Trading Center