By Colin Dodds ·October 23, 2023 · 8 minute read
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A short squeeze is a market event in which short sellers quickly close out bearish positions in a stock, leading to a dramatic surge in the share price. Short squeezes typically occur after a company stock posts a sudden increase. This causes short sellers to try to exit a bearish position quickly.
In order to exit their short positions, these investors have to actually buy back shares they’ve lent out. This causes further gains in the share price, sometimes to dizzying levels.
What Is a Short Squeeze?
As mentioned, a short squeeze is an event in the market that involves short sellers quickly selling or closing out their positions, which in turn, causes changes in the share price of a security.
There are many investors, both retail and institutional, who use short selling to bet that a given stock will go down over a fixed period of time. But short selling is incredibly risky as stock prices have historically tended to drift upward. And timing a bearish position can also be picky. Even if an investor has good reason to believe that a company’s shares will fall, it could be some time before they actually do.
What Causes Short Squeezes?
To understand how short squeezes occur, we first have to understand how shorting a stock works. To sell a stock short, an investor must first borrow the shares. They then consequently sell in the open market. At an agreed-upon time, the investor will buy back the shares in order to return them to the original lender.
If the stock goes down between the time they borrow the stock and when they return it the investor makes money. That’s because they pocket the difference between what they sold the stock for and what they purchased it for when it came time to return it.
And if those short investors borrow a stock that goes up instead of down, they lose money.
Example of Short Selling
Let’s look at a hypothetical case of a short sale. Let’s say an investor borrows a stock that’s trading at $10 with an agreement to pay back the shares in 90 days.
The investor then sells the stock for $10. Then 90 days later, if the stock is trading at $5, they can buy back the number of shares they borrowed and return them to the lender, capturing the $5 per share profit (often minus interest and fees).
Example of Short Squeeze
Now, let’s use this example to look at a short squeeze. Let’s say the investor borrows the stock again that’s trading at $10 with an agreement to pay back the shares in 90 days.
This time however, the share price shoots up to $15. The investor still has to buy the shares they borrowed and return them to the lender. But other investors are also trying to cover their shorts as well, so there’s a shortage of shares in the market to buy back.
The shortage causes the stock’s price to jump even higher to $20, which in turn triggers other short sellers to close their positions. They have to now also purchase back shares, and hence a buying frenzy and short squeeze occurs.
Theoretically, there’s no limit to how much money short sellers can lose. When an investor is long a stock but wrong, the share prices can only go down as low as $0. But when an investor is short and wrong, the share prices can go infinitely higher, making it possible losses can be limitless for the short-selling investor.
Recommended: How Low Can a Stock Go?
Famous Short Squeezes
One famous example of a short squeeze occurred in 2021, when electronics retailer GameStop saw its shares jump 2,300% in a few weeks as a wide range of investors looked to take advantage of the high number of short sellers in the stock. This was during the “meme stock craze” that overtook the market that year.
Another example occurred in 2008, when automaker Volkswagen briefly became the world’s most valuable stock by market cap when it became known that Porsche was increasing its stake in its fellow German carmaker.
What’s a Long Squeeze?
By contrast, a long squeeze is when short sellers drive down the price of a stock or asset until the bullish investors begin to sell their positions in response, driving the price lower still. It can be helpful to review short positions vs long positions to get a deeper understanding of a long squeeze.
💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
What Was the MOASS?
The “MOASS” is an acronym for the “Mother of all short squeezes.” And it’s more or less exactly what it sounds like: A monstrous short squeeze event in the market.
The short squeeze involving GameStop shares, as mentioned above, is perhaps the best and most recent example of a MOASS. Many institutional investors had shorted GameStop stock, anticipating that its value would fall, but groups of day traders worked together to drive up demand of the stock, and its value. This “squeezed” the short sellers, and caused many big firms to lose significant amounts of money on their positions.
How to Trade a Short Squeeze
Given the chance for dramatic returns, many investors have taken an interest in getting in on the winning side of a short squeeze.
To invest in a short squeeze, traders start by surveying the markets for stocks that have garnered substantial interest from short sellers. This factor is often called “short interest,” and as a metric, it represents the number of a company’s shares that have been sold short, but not yet returned to the lender. Traders know that the short sellers of all those shares will have to buy back shares – at any price – to return them to the lender.
There are two ways to understand short interest. One is short interest percentage, which shows how many of a company’s overall shares are currently shorted. A higher number means that more short sellers will be bidding up the stock to buy it back. The second metric is short interest ratio, which shows how much short sellers are responsible for a stock’s daily trading volume. A higher ratio means it’s likely that short sellers will help drive up the stock’s price once it starts to rise.
Another key metric has to do with when the short sellers will have to deliver those shares to the lender. It’s known as “days to cover,” and it’s the ratio comparing the total short-selling interest in a stock with the average daily shares that trade. As a metric, it gives traders a sense of how long until short sellers buy back the stocks they borrowed for their short positions.
Stocks with a high short-interest number and a high days-to-cover number are vulnerable to a short squeeze. Once these traders find stocks that seem like short-squeeze candidates, they buy the stocks outright, and watch those key metrics, along with the news, to decide when to sell. Short squeezes can make a stock shoot up, but those returns often evaporate quickly.
Short Squeezes vs Naked Shorts
As discussed, shorting typically involves borrowing shares to create tenable positions. Naked shorts, often involving naked options, are a type of short selling, but it involves not borrowing, or otherwise securing possession of, shares before making a trade or taking a short position. This leaves the trader “naked” in the event that a trade goes south.
Risks of a Short Squeeze
While short squeeze investments can produce eye-popping returns in the short term, they come with real risks for individual investors, and institutions.
Risks for Investors
For investors, perhaps the biggest risk of a short squeeze is that they’ll get caught on the wrong side of one, and lose some money. Obviously, that’s a risk for institutions as well, but individual investors likely don’t have as many resources on hand to try and recover.
Similarly, investors may misread the room – that is, not quite understand what’s happening in the market, and misjudge their position. They’ll also need to be vigilant in watching their positions to make sure they change those positions at the right time.
Risks for Institutions
Most of the risks involved with short squeezes for individual investors hold true for institutions, too.
For instance, the risks involved with stocks themselves include the fact that stocks with a high short-interest number may be undervalued or misunderstood, or they may simply be failing businesses. And if there is no good news, or market interest, they may continue to sink.
At the same time, the price increases caused by short squeezes are short-lived. Once the short-sellers have paid back their lenders, the market runs out of buyers who will pay any price for that stock. And the share prices often fall as quickly as they rose. The danger to traders in a short squeeze is that they’ll get in too late and stay in too long and lose money.
Long-term investors may try their hands at winning a short-squeeze trade here and there. But it requires deep research, constant monitoring and the ability to move in and out of a stock quickly – something that institutions may have access to more so than individuals.
Investing With SoFi
A short squeeze is a market event in which investors inadvertently bid up the price of a heavily shorted stock, while trying to get out of their bearish positions. In order to buy the stocks that investors borrow to sell short, those investors must buy the stock at ever-increasing values.
Short squeezes involving short positions and financial derivatives are relatively high-level concepts and may involve a skilled hand in navigating. For that reason, it may be worth discussing them, and their risks, with a financial professional.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Are short squeezes legal?
Short squeezes are a natural occurrence in the stock market, but market manipulation is illegal. As the SEC says, “abusive short sale practices are illegal,” and that may play into short squeezes. As such, it’s a gray area.
What is the biggest short squeeze of all time?
While the Volkswagen short squeeze in 2008 was one of the largest of all time, the GameStop short squeeze was, perhaps, the largest of all time, and the most notable recent example of a short squeeze.
How high can a short squeeze go?
Theoretically, there is no limit on how high a stock can go, and accordingly, how high a short squeeze can go.
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