A short squeeze happens when a stock suddenly spikes - a bind for traders who bet borrowed money it would drop

Jim Probasco

Feb 6, 2021, 10:52 IST

A short squeeze happens when a stock suddenly spikes - a bind for traders who bet borrowed money it would drop

A short squeeze afflicts short-sellers, investors who have sold sell stocks they don't actually own, in hopes of buying them back later for less money. If the stock rises instead, the strategy goes awry.Pichsakul Promrungsee / EyeEm/Getty Images

A short squeeze refers to a stock rise in price, adversely affecting investors who'd expected a decline.
Signs of an imminent short squeeze include heavy buying or a high amount of a stock's shares being sold short.
Buy-limit orders and hedging strategies offer short-sellers some protection against a short squeeze.

In late January 2021, shares of a company called GameStop stock, which had been trading around $2.57 per share, suddenly shot up, eventually as high as $500 - when users of the Reddit website subgroup Wall Street Bets began buying up shares.

This was bad news for a lot of other investors, known as short-sellers, who had bet the stock would keep falling. Unlike most investors, who want their stocks to appreciate, short-sellers make money when stock prices go down and lose money when they go up.

So when GameStop started gaining, these short-sellers were caught in what's called a short squeeze. They had borrowed to support their pessimistic investment, and they now had to pay it back - by buying GameStop shares at the higher prices. Or else, hang on - and risk losing even more money.

A short squeeze is a stock market phenomenon, something that happens to investors and traders who have acted on the assumption that an asset (a stock, usually) is going to fall - and it rises instead. Here's how it happens.

What is a short squeeze?

To understand a short squeeze, it helps to understand short selling, aka shorting, a sophisticated investment strategy in which traders or investors sell stocks they don't actually own, in hopes of buying them back later for less money.

It works like this: A short-seller borrows shares (usually from their broker) they think are due for a fall or to keep on falling, and sells them on the open market at the current price. When the stock's price drops, as the short-seller was betting it would, they then buy the shares back for the new, lower amount. They return the borrowed shares to their stockbroker, keeping the difference in price as profit. In the interim, they're charged margin interest on the shorted shares until they pay them back.

The entire strategy hinges on the bearish view that the stock is going to drop in value. But what if it goes up instead? That's when a short squeeze happens.

When a stock rises sharply and suddenly, short-sellers scramble en masse to buy shares to cover their position (their loan from their broker). Each of these buy transactions drives the stock even higher, "squeezing" the short-seller even more. They have to keep covering their positions or get out totally - at a loss.

How does a short squeeze happen?

Here is how a short squeeze scenario unfolds:

You identify a stock you believe is overvalued, and take a short position: borrowing and selling shares at today's high price in anticipation the price will go down and you will be able to buy replacement shares at a much lower price.
Instead, something happens causing the price of the stock to start going up. That "something" can be the company issuing a favorable earnings report, some sort of favorable news for its industry - or simply many other investors buying the stock (as happened with GameStop).
You realize you are unable to buy the stock back at a low price. Instead of sinking, it's climbing - and it exceeds the price you bought it for. At this point, you must either buy replacement shares at a higher price and pay back your broker at a loss, or buy even more shares than you need - in hopes that selling them for profit will help cover your losses.
All this increased buying causes the stock to keep going up, forcing even more short-sellers like yourself into a tighter vise. You have the same choices as above, only the stakes keep mounting, and so do your potential losses.

Protecting yourself against a short squeeze

There are specific actions you can take to try to protect yourself against a short squeeze or to at least alleviate its grip.

Place stop-loss or buy-limit orders on your short positions to curb the damage. For example, if you short a stock at $50 per share, put in a buy-limit order at a certain percentage (5%, 10% or whatever your comfort level is) above that amount. If the shares rise to that price, it'll automatically trigger a purchase, closing out your position.
Hedge your short position with a long position - that is, buy the stock (or an option to buy the stock) to take advantage of rising prices. Yes, you're betting against yourself, in a way, but at least you lessen the damages of the losses and benefit from the price appreciation.

Predicting a short squeeze

Short squeezes are notorious for descending quickly and unpredictably. Still, there are signs a short squeeze may be coming:

Substantial amount of buying pressure. If you see a sudden uptick in the overall number of shares bought, this could be a warning sign of a pending short squeeze.
High short interest of 20% or above. "Short interest" is the percentage of the total number of outstanding shares held by short-sellers. A high short interest percentage means a large number of all a stock's outstanding shares are being sold short. The higher the percentage, the more likely a short squeeze may be building.
High Short Interest ratio (SIR) or days to cover above 10. SIR is a comparison of short interest to average daily trading volume. It represents the theoretical number of days, given average trading volume, short-sellers would need to exit their positions. The higher this number, the more likely a short squeeze is coming. Both short interest and SIR are on stock quote and screener websites such as FinViz.
Relative Strength Index (RSI) below 30. RSI indicates overbought or oversold conditions in the market on a scale of 0 to 100. A stock with a low RSI means it's oversold - that is, trading at a very low price - and possibly due to increase; a high RSI indicates the stock is extremely overbought - trading at a high price - and possibly due to drop. Any RSI below 30 signals an imminent price rise, which could lead to a short squeeze. A company's online stock listing usually includes its RSI, often under its Indicators section.

The financial takeaway

A short squeeze can result when a stock - especially one that had been declining in price - suddenly goes up for whatever reason.

This puts short-sellers, who bet the stock would drop or to keep on dropping, in a bind. They sold shares they didn't actually own, and now, to cover their positions - repay the stock they borrowed -they have to buy increasingly expensive shares. Each of these buy transactions drives the stock even higher, forcing more short-sellers to spend more or get out at a loss. They call it a squeeze but it becomes more like a vicious cycle.

There are indicators to predict a short squeeze, and ways to protect yourself against one. But overall, a short squeeze is one of the facts of life for a short-seller - and a reminder of the risks that sophisticated trading strategies like short selling carry.