What Is a Short Squeeze?
A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall to buy it in order to forestall even greater losses. Their scramble to buy only adds to the upward pressure on the stock's price.
- A short squeeze accelerates a stock's price rise as short-sellers bail out to cut their losses.
- Contrarian investors try to anticipate a short squeeze and buy stocks that demonstrate a strong short interest.
- Both short-sellers and contrarians are making risky moves. A wise investor has additional reasons for shorting or buying that stock.
Short-sellers borrow shares of an asset that they believe will drop in price in order to buy them after they fall. If they're right, they return the shares and pocket the difference between the price when they initiated the short and the actual sale price. If they're wrong, they're forced to buy at a higher price and pay the difference between the price they set and its sale price.
Short sales have an expiration date, so when a stock unexpectedly rises in price, the short-sellers may have to act fast to limit their losses.
Understanding the Short Squeeze
The flight of short-sellers and their impact on the stock's price is known as a short squeeze. Short sellers are being squeezed out of their positions, usually at a loss.
Short sellers zero in on a stock that they think is overvalued by the market. For example, Tesla captured the enthusiasm of many investors with its innovative approach to producing and marketing electric vehicles. Investors bet heavily on its potential. Short sellers bet heavily on its failure. In early 2020, Tesla was the most-shorted stock on the U.S. exchanges, with more than 18% of its outstanding stock in short positions.
In late 2019 through early 2020, Tesla stock soared by 400%. Short sellers got hammered, collectively losing about $8 billion. In early March 2020, Tesla's stock finally fell, along with most others, during a market downturn. Short sellers made about $50 billion in a sell-off that lasted a few days.
Why Short Squeezes Happen
As noted, short-sellers open positions on stocks that they believe will decline in price. However sound their reasoning is, it can be upended by a positive news story, a product announcement, or an earnings beat that excites the interest of buyers.
The turnaround in the stock’s fortunes may prove to be temporary. But if it's not, the short seller can face runaway losses as the expiration date on their positions approaches. They generally opt to sell out immediately even if it means taking a substantial loss.
The percentage of Tesla stock that represented short interest in late 2019. Its stock price quadrupled, and short-sellers lost billions.
That's where the short squeeze comes in. Every buying transaction by a short-seller sends the price higher, forcing another short-seller to buy.
How to Measure Short Interest
Two measures useful in identifying stocks at risk of a short squeeze are short interest and the short-interest ratio. Short interest is the total number of shares sold short as a percentage of total shares outstanding. Tesla's 18% short interest was extremely high. The short-interest ratio is the total number of shares sold short divided by the stock’s average daily trading volume. Speculative stocks tend to have higher short interest than more stable companies.
Watching short interest can tell you whether investor sentiment about a company is changing. For example, if a stock typically has a 15% to 30% short interest, a move above or below that range could signal investors have shifted their view on the company. Fewer short shares could mean the price has risen too high too quickly, or that the short sellers are leaving the stock because it has become too stable.
A short position can be defeated by a positive news story, a product announcement, or an earnings beat.
A rise in short interest above the norm indicates investors have become more bearish. But an extremely high reading could be a sign of a coming short squeeze, which could force the price higher.
Betting on a Short Squeeze
Contrarian investors may buy stocks with heavy short interest in order to exploit the potential for a short squeeze. A rapid rise in the stock price is attractive, but it is not without risks. The stock may be heavily shorted for good reason, such as it has a dismal future outlook.
Active traders will monitor highly shorted stocks and watch for them to start rising. If the price begins to pick up momentum the trader jumps in to buy, trying to catch what could be a short squeeze and a significant move higher.
Risks of Trading Short Squeezes
There are many examples of stocks that moved higher after they had a heavy short interest. But there are also many stocks that are heavily shorted and keep falling in price.
A heavy short interest does not mean the price will rise. It means that many people believe it will fall. Anyone who buys in the hopes of a short squeeze should have other, and better, reasons to think that the price of the stock will go higher.
Example of a Short Squeeze
Consider a hypothetical biotech company, Medicom, that has a drug candidate in advanced clinical trials.
There is considerable skepticism among investors about whether this drug will actually work. As a result, there is heavy short interest. In fact, five million Medicom shares have been sold short of its 25 million shares outstanding. That means the short interest on Medicom is 20%, and with daily trading volume averaging one million shares, the short-interest ratio is five. The short interest ratio, also called days-to-cover, means that it will take five days for short sellers to buy back all Medicom shares that have been sold short.
Assume that because of the huge short interest, Medicom had declined from $15 a few months ago to $5. Then, the news comes out that Medicom’s drug works better than expected. Medicom’s shares jump to $9, as speculators buy the stock and short-sellers scramble to cover their short positions.
Everyone who shorted the stock between $9 and $5 is now in a losing position. Those who sold short near $5 are facing the biggest losses and will be frantically looking to get out as they are losing 80% on their investment.
The stock opens at $9, but it will continue to rally for the next several days as the shorts continue to cover their positions and new buyers are attracted by the rising price and positive news.