When you short a stock, you’re essentially borrowing shares using a margin account. You then immediately sell the borrowed shares in hopes that the share price will drop. If you’re right, you can buy the stock for a lower price and return it to the owner. Your profit is the difference between the price you sold the stock for and what you paid to buy it back. If you’re wrong, though, your losses are often unlimited. You will have to buy the stock back to close out your position, no matter how high the price soars. This is a short squeeze, as it occurs when the price of a heavily shorted stock shoots up. Short sellers then have to pay higher prices to close their positions, creating more upward pressure. One notorious short squeeze occurred in early 2021, when traders in the subreddit WallStreetBets pushed up GameStop shares in an unheard-of way. The cost of shares rose by hundreds in a matter of weeks. Before 2021, the stock’s previous closing high was $62.88. On Jan. 29, just weeks after the Reddit post gained attention, shares closed at $325.
How Does a Short Squeeze Work?
There are no regulations that dictate the time limit for when a short seller has to close out their position. However, if you’ve shorted a stock in your account, in some cases, your broker may require you to do so, which means you’ll have to buy back the stock at the current market price. This is the case for financial services company Charles Schwab. When a stock is thinly traded or heavily shorted, this can trigger a short squeeze, as many investors have to close out their positions at once. Short squeezes can happen naturally, too, when share prices leap in response to unexpected news. Let’s take a look at an example. Suppose an imaginary company called Driverless is trading at $50 a share. There’s big hope riding on its technology for self-driving cars, but many investors are skeptical it will get the necessary approvals. Short interest grows as a result. When Driverless gets an important approval, its share prices skyrocket to $60. The investors who shorted the stock for $40 start to panic. They want to close their positions as soon as possible, before share prices rise even more. In their frenzy to get out, investors who shorted Driverless push up its shares to $70, then $80, then $90, and beyond. The huge run-up has nothing to do with the fundamentals of the stock, but rather is caused by short sellers desperate for an exit pumping up the price. A short squeeze can also happen for other reasons too, as occurred with GameStop. Billion-dollar hedge fund Melvin Capital Management LP disclosed in a November 2020 13-F filing with the U.S. Securities and Exchange Commission (SEC) that it had taken a short position in the retailer’s stock. After learning of the position, WallStreetBets users began buying up the stock, causing share prices to skyrocket. Between Jan. 4 and Jan. 27, 2021, GameStop shares spiked from $17.25 to $483.
What It Means for Individual Investors
Short selling can be used by investors for many reasons, including to profit from an unexpected drop in a stock’s price, to provide liquidity when there is unanticipated buyer demand, or to hedge the risk of a long position in the same security. Shorting stocks is highly risky. Your potential losses are unlimited, yet your potential returns are limited. The most you can earn is the difference between the price you sell your borrowed shares for and the price you pay to buy them back. While short squeezes of GameStop, along with other meme stocks like AMC Theatres and Blackberry, made headlines in 2021, many stocks that are heavily shorted actually do go on to plummet. If this occurs, it’s the short sellers who profit and the regular shareholders who incur huge losses. If you want to spot a stock that could be vulnerable to a short squeeze, there are two key metrics to look for:
Short interest: This is the percentage of outstanding shares that have been sold short. If a stock’s short interest is significantly higher compared to its peers, or it’s rapidly rising, a short squeeze is likely to occur. Days to cover ratio (short interest ratio): This is the current number of shorted shares divided by the average daily trading volume. For example, if there were 10 million shorted shares of a company and the average daily trading volume was 4 million, the days to cover ratio would be 2.5. This means it would take 2.5 trading days to cover all short positions. The higher this number, the greater the chances of a short squeeze.
