Erik Weijers, 8 months ago

What is a short squeeze?

Shorting a stock or crypto is trying to profit from a drop in the price. You borrow the shares and sell them immediately, hoping for further price declines. If the reverse happens, you find yourself forced to buy back at a higher price. If a large proportion of traders are forced to do that, it leads to a fierce price rise: the short squeeze.

The opposite of a short squeeze is a long squeeze. In that case, many traders have speculated on a price rise, but the opposite happens. So, a squeeze is always the fierce price movement as a group of traders exit their positions en masse. This fire is then further fueled by changing sentiment: 'hey, the price is rising (dropping), maybe I should buy (sell) too'.

How does shorting work and how can a short squeeze occur?

  1. The short seller borrows shares (or crypto coins) from a trading house and immediately sells them onto the market. The hope is that the stock price will fall and he can buy them back lower.
  2. Later, the short seller must buy back the borrowed shares at the current price to close his position.
  3. If the stock price falls, he can buy back the shares and profit from the difference.
  4. Does the stock price rise? Then the loss can add up quickly. The short seller will be tempted to take a small loss instead of a potential huge one, and buy back the shares at the higher price. The short squeeze occurs when this happens en masse: it is a chain reaction of more demand leads to price rises.

Why a short squeeze is risky

A short seller must eventually return the borrowed shares. But he of she has already sold them. And because the price of a stock has no upper limit, the potential loss is also unlimited. This is another reason short sellers often sell when they are slightly at a loss: they would rather not wait for potentially huge losses.

Well-known short squeezes: Tesla and Gamestop

Short sellers believed in late 2019 that the market had overly excessive expectations for Tesla. The stock accounted for 18% of all open short positions. But Tesla stock kept rising, some 400% during that period. Short sellers were squeezed and collectively lost 8 billion. With the March 2020 covid crash, they had a chance to make up for that: then Tesla shares fell hard (as did all markets).

In January 2021, a short squeeze took place on the shares of US video game business GameStop. When traders on the subreddit wallstreetbets realized that hedge funds had sold 140% of Gamestop's public shares short, it was game on. The artificially and impossibly high borrowing ratio was crucial here. Shorters, when the price goes up, have to buy back shares. But how can you buy back shares that are not on the market? This is also called naked shorting and even riskier than shorting. Gamestop's stock was at $17 before the short squeeze and at its peak at $500. The shorters from the hedge fund Melvin Capital lost around $6 billion and put a stop to the fund a year later. It was a Robin Hood like story of ordinary folks punishing greedy Wall Street for wanting to bring down a likeable brand.

Trading a short squeeze

Like tornado chasers, there are traders who scout for stocks or crypto on which there are many short positions. For example, the trader checks if the "short interest" is high. That is the number of shares sold short as a percentage of the number of shares outstanding. If that percentage is high, conditions become possible for a short squeeze. But, of course, there's no guarantee. The stock price may just keep falling. As a trader, you must have good reasons to believe that the stock is undervalued if you want to bet against the shorters.

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