Earlier this year, one of the stocks I owned more than doubled in price overnight. This isn’t a natural occurrence for most investments, and the stock in question had been languishing before its jump. When I researched what had happened, I saw that the rise in price was due to a short squeeze. In all my years I’ve never run into this situation. Here’s an introduction to a short squeeze in case it happens to a stock you own.
Selling short
Before talking about a short squeeze, it’s important to understand about selling short. Most investors purchase a stock in the hopes that it will rise and bring riches, or at least enough for a down-payment on a home or their kid’s college education. Short sellers think the price of a share is going to decline, so they sell these shares and then will purchase them at a later date (when the price has moved in the direction they hoped), making a profit off the difference between the high price at which they sold and the low price at which they later purchased.
If you’ve seen the movie Trading Places, you’ve seen a classic short sale. Basically, they sell orange juice futures as the price is increasing and then repurchase them when the market self-corrects to a lower price.
How do short sellers get their shares?
If an investor wants to sell an investment short, they must borrow the investment from the broker. This is set up through a process called securities lending, in which investors who own a stock will agree to loan it to another party. Often institutional investors or college endowment funds will lend their shares to make a little more income from their holdings.
The short seller, through a margin account, will borrow these shares, agreeing to pay a certain amount of interest during the transaction. Since they think the price will drop, short sellers usually sell their borrowed shares quickly, then wait until the price hits their predetermined lower level before repurchasing and closing out their position.
Uh-oh. The price is going up.
Now that you understand some of the background, here’s how a short squeeze works. When a heavily shorted stock starts to experience buying pressure, the stock price begins to rise. As the price rises, short sellers start to feel the heat, knowing that they will have to buy back the shares they borrowed at a higher price.
To cover their positions, short sellers start buying shares on the market. This increased buying activity further drives up the stock price, triggering a chain reaction of more short sellers rushing to buy back shares, fueling the squeeze even more.
Why does this happen?
As noted above, a short squeeze is triggered by an increase in the stock price. Some of the reasons a stock might surprisingly increase in price include:
Positive news or earnings result. When unexpected good news hits, investors become more optimistic about the stock’s prospects, leading to increased buying pressure. Short sellers, realizing they may have misjudged the situation, scramble to exit their positions.
Short-term calalysts. Analyst upgrades, favorable market conditions, or even social media hype can also trigger a short squeeze because they may create a sense of urgency, pushing short sellers to cover their positions.
GameStop
In early 2021, one of the most memorable short squeezes involved the video game retailer GameStop. The company’s stock price had been heavily shorted by hedge funds, betting on its decline. However, a group of individual investors on Reddit’s WallStreetBets subreddit banded together and initiated a buying frenzy, causing the stock price to skyrocket. This unexpected surge caused a panic among short sellers, who were forced to buy back shares at much higher prices.
My stock
No, my stock wasn’t GameStop. After several days at heightened prices, the buying frenzy calmed down and the stock returned to its previous price. This is similar to what happened to GameStop after a period as well. People who invested when the stock was in the hundreds of dollars saw their investment wither away.
There are some investors who try to spot stocks vulnerable to a short squeeze, hoping to make money off the sudden burst in prices. If you’re curious, research more on short interest and the days to cover ratio as well as how to make money off short squeezes. Just note that it’s incredibly difficult to be successful in this endeavor. If you’re fortunate enough to own a stock that experiences a short squeeze, double check your sell price or sell decision. If the price goes high enough, consider selling when it reaches your planned exit price.
Photo by Ludovic Migneault