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What is a 'Short Squeeze'

A short squeeze is 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. It implies that short sellers are being squeezed out of their short positions, usually at a loss, and 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'

A short squeeze is a big risk associated with short selling. 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.

Betting on a Short Squeeze

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.

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