What Is Short Selling?
When an investor sells a stock short, it means they have borrowed shares at what they hope is a high price. They sell those borrowed shares at the price the stock was at when they borrowed them. At some point in the future, they must buy shares so that they can return them to the lender.
The best-case scenario is that the price falls, so the short-seller can buy the shares for a lower price than what they sold them for when they borrowed them. However, if the price rises instead of falls, a short squeeze can occur.
What Is a Short Squeeze?
Short-sellers borrow shares and sell them because they expect the price to fall, enabling them to pocket the difference between the price at which they borrowed and sold the shares and the price at which they buy the shares later.
However, if the stock price increases a lot in a relatively short amount of time, they may cut their losses by buying shares at the higher price. When this happens, the short-sellers are squeezed out of their position, being forced to buy shares at a loss.
Short-sellers exit their position by purchasing shares to return to the lender.
How a Short Squeeze Happens
A short squeeze occurs when the price of a stock with a significant amount of short interest, is surging. The squeeze creates a positive feedback loop that sends the stock price higher and higher.
Short squeezes are somewhat rare. In order for a short squeeze to occur, there must be a large number of short-sellers that together hold a significant number of shares short. Now, any positive catalyst in such a situation may cause short sellers to start panicking leading to increased buying of the stock as the short sellers begin to cover their positions. Many stocks that enter a short squeeze have a relatively small number of outstanding shares and a small market capitalization, although short squeezes can also occur in larger stocks, putting billions of dollars on the line.
When there's a large amount of short interest in a stock, a short squeeze can be triggered by something as simple as a positive earnings report or news headline. As more and more short-sellers are forced or decide to cover their positions by buying the stock, the price rises higher and higher. Sometimes a short squeeze convinces other investors to buy, sending the price up even further.
Key Takeaway: As the price climbs, some short-sellers may feel the heat and decide to cut their losses, so they buy shares to cover their position. Those purchases send the stock price even higher, causing more short-sellers to cover their positions. The result is an even higher and higher stock price until the short interest is tapped out.
Identifying Short Squeeze Stocks
To identify stocks where a short squeeze may occur, investors can look out for several things, including the following.
1. High Short Interest
Investors should keep an eye out for stocks with high short interest. Short interest refers to the percentage of outstanding shares that are being sold short. Short interest is important because it reveals how investors feel about a particular stock. If a large percentage of a stock's shares are sold short, there is a chance of a short squeeze occurring if the price rises suddenly.
2. Short-Interest Ratio
Another important metric to look at when trying to identify stocks where a short squeeze may occur is the short-interest ratio. It weighs the amount of short interest against the stock's average daily trading volume.
The short-interest ratio measures the number of days it would take all short-sellers to exit their positions based on the average daily trading volume. The higher the short-interest ratio, the greater the chance of a squeeze.
3. Relative Strength Index
The relative strength index is also an important metric to look at because it shows whether a stock is oversold or overbought. The scale is zero to 100, and anything under 30 suggests a short squeeze is likely if other conditions are met. A low relative strength index indicates that the stock is oversold and that its price could rise, leading to a short squeeze if the short interest is high.
Betting on a Short Squeeze
Investors bet on a short squeeze by identifying and buying stocks that have indicators that a short squeeze may be imminent. Investors can also bet on a short squeeze by buying a stock with high short interest as it starts to rise. The initial increase in the stock price could lead to a short squeeze if it continues, sending the price higher and higher.
Risks of a Short Squeeze
As with any investment, there are some risks of betting on a short squeeze. The biggest risk is that the short squeeze will never pan out. Not every stock with high short interest will go through a squeeze. Sometimes the reasoning behind going short on a particular stock is strong enough that it will decline even though short interest is high.
It's a good idea for investors who want to bet on a short squeeze to have other reasons for buying the stock. For example, if they disagree with the reasoning behind the short-sellers' bet, they might buy the stock because they think it will rise despite the high short interest.
Tip: It's a good idea to have another reason to buy a stock besides betting on a short squeeze.
Example of a Short Squeeze
Let's say Company A is targeted by a short-seller who issues a report publicizing his short thesis. The short-seller alleges fraud in the company and bets that its stock will fall. Based on that thesis, many other investors go short on the stock because they believe there is fraud. Short interest reaches 25% of Company A's outstanding shares.
However, the company follows up the short-seller's report with evidence that there is no fraud, and its shares start to rise. Short-sellers who had bet on the stock declining realize that they are wrong, so they start buying shares to cut their losses. The stock keeps on rising as more and more short-sellers buy shares to cover their positions, which in turn convinces other investors to buy shares.
Historic Short Squeezes
1. Northern Pacific Railway Short Squeeze
In 1901, Edward Henry Harriman faced off with James J. Hill for control over the Northern Pacific Railroad. Both started buying up as many shares as they could get their hands on in an attempt to seize control of it.
Other investors then started shorting Northern Pacific because they felt the price had gotten too high in the war between Hill and Harriman. However, Hill and Harriman kept buying Northern Pacific shares, sending the price higher and higher until short-sellers got squeezed out.
The spat between Hill and Harriman spilled over into the rest of the market, resulting in the Panic of 1901. Neither of them would sell their shares, and there weren't enough non-committed shares to cover the outstanding short positions. As a result, short-sellers sold other positions to raise the cash they needed to buy Northern Pacific shares and cover their positions.
2. Piggly Wiggly Short Squeeze
Clarence Saunders founded Piggly Wiggly, the first full-service grocery store chain, and he took on Wall Street himself by attempting to orchestrate a massive short squeeze. Toward the end of 1922, just months after Piggy Wiggly stock was listed on the New York Stock Exchange, some investors started betting against it.
Saunders was angry that investors were betting against his company, so he started buying up as many shares as he could in an attempt to trigger a short squeeze. Saunders owned 99% of Piggy Wiggly's stock by March 1923, which meant short-sellers would have had to buy from him to cover their positions.
However, short-sellers complained to the New York Stock Exchange, which was operated by Wall Street insiders. Saunders successfully triggered a short squeeze in Piggy Wiggly shares by calling in the shares he had loaned to short-sellers, who had to rush to buy shares to pay him back. However, his victory was short-lived as the New York Stock Exchange eventually suspended trading on the grocery store chain.
3. Volkswagen (VW) Short Squeeze
In 2008, shares of Volkswagen more than quadrupled in only two days following the news that Porsche had been buying up shares of the German automaker. Short-sellers hurried to cover their positions after hearing that Porsche was building a position in Volkswagen, resulting in a short squeeze. Volkswagen shares plunged almost 60% in the four days after the squeeze, giving most of it back.
4. GameStop (GME) Short Squeeze
In 2021, retail investors started to buy up shares of several companies with high short interest in an attempt to squeeze out hedge funds that were shorting them. GameStop became the poster child of this effort by retail investors, having been one of the first to be targeted.
Using the Reddit forum WallStreetBets to organize, retail investors orchestrated their effort after about 140% of GameStop's float had been sold short. Hedge funds had bet against the company because it had been struggling as video game spending moved online.
In early 2021, retail investors bought up shares of the video game retailer, sending the share price higher and higher and triggering a short squeeze that nearly bankrupt at least one hedge fund.
Gamma Squeeze vs. Short Squeeze
Naked short selling involves illegally selling short shares that don't exist. Generally, investors must determine whether a stock can be borrowed before they sell it short. However, when investors short a stock without confirming that the shares can be borrowed, the amount of short interest may be higher than the number of outstanding shares.
When there's a short squeeze, naked short selling essentially creates phantom shares, increasing liquidity in the shorted stock. In the event of a short squeeze, short-sellers who haven't borrowed the shares they shorted will fail to deliver those shares because they don't exist.
A gamma squeeze differs from a short squeeze because it involves the options market. A gamma squeeze forces investors to buy shares because of open options positions on the stock. Sellers of naked call options see their potential loss increase as the stock price rises. They can hedge their position by purchasing the stock at any time before the option is exercised, which converts their naked calls into covered calls.
