What is a Short Squeeze?

A short squeeze is a situation in which a heavily shorted stock or commodity moves sharply higher, forcing short sellers to close out their short positions and adding to the upward pressure on the stock. Short sellers are being squeezed out of their short positions, usually at a loss. Short squeezes are 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 the position even if it means taking a substantial loss.

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Short Squeeze

Short Squeeze Basics

A short squeeze is a 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 short interest and the short interest ratio. Short interest refers to the total number of shares sold short as a percentage of total shares outstanding. The short interest ratio is the total number of shares sold short divided by the stock’s average daily trading volume.

These measures are useful when compared to prior readings within a stock. Since some speculative stocks always tend to have higher short interest than more stable companies, investors look for behavior that is out of the ordinary for a particular stock.

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 (10% for example) 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 or bullish. A rise in short interest above the norm (35% for example) indicates investors have become more bearish, but it is also an extreme reading which could result in a short squeeze and the price moving higher.

When short interest is very high, or at least higher than what is normal for a stock, it could result in a short squeeze because it is possible that everyone who wants the stock go down has already taken a position. In the example above, if the short interest is 35%, and 30% is already a high number of short-sellers for the stock, then a larger than usual number of people have placed their bets on the stock going down. If instead, the stock rises, because there is no one left to sell or short, then the price could rise rapidly as the large group of short sellers scramble to exit their short positions by buying.

Betting on a Short Squeeze

Contrarian investors look for stocks with heavy short interest because of the short squeeze potential. 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.

Investors who bet on a short squeeze occurring may accumulate long positions, typically while getting confirmation from other technical price patterns or indicators, or positive fundamental data.

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. As indicated, a heavy short interest is often just an indication that the company is doing poorly or people don't believe it is has a strong future.

This is why people who buy in the hopes of a short squeeze happening typically have other analysis which indicates the price of the stock should go higher anyway.

Another thing to keep in mind is that a short squeeze can be brief. It may result in a temporary move higher in price, which is then quickly reversed by people who use the higher price as an opportunity to sell.

Key Takeaways

  • A short squeeze occurs when there are a large number of short positions that need to cover before the price rises further.
  • A short squeeze could be temporary or result in a longer-term price rise if the company is able to generate a more positive outlook for its investors.
  • Just because a stock has a lot of short interest, or a high short interest ratio, doesn't mean it will move higher in price due to a short squeeze.
  • Traders who bet successfully on short squeezes, and the price rises they generate, utilize other forms of analysis as well. There should be other bullish signals that the price is ready to rise, as short interest data should not be acted on alone.

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, and as a result, five million Medicom shares have been sold short of its 25 million shares outstanding. Short interest on Medicom is therefore 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 currently. News comes out that Medicom’s drug works better than expected. Medicom’s shares gap higher on the announcement, 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 frantically be looking to get out as they are losing 80%. Such a loss could trigger margin calls. If those margin calls can't or won't be met, then the short positions will be liquidated, pushing the price up higher. While the stock may open at $9, it may 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.