Short Squeeze

What is a Short Squeeze?

A short squeeze is a phenomenon that occurs when there is a sharp increase in the price of a stock that has a high level of short interest. Short interest refers to the total number of shares that have been sold short but have not yet been closed out or covered.

The squeeze happens when short sellers, who have bet that the stock price will decline, are forced en masse to buy back the stock to close out their short positions, typically at a major loss.

This sudden surge of buying pressure from short sellers scrambling to cover their positions drives the stock price up even further.

As short sellers who bet against a stock hurry to finish their trades by purchasing all the shares they can get, their moves make the stock price go higher and higher in a repeating pattern.

The rapid rise in the stock price “squeezes” the short sellers out of their position. This is why the phenomenon is referred to as a “short squeeze.”

How a Short Squeeze Unfolds?

Short squeezes tend to occur with stocks that have already been declining in price and have consequently attracted a lot of attention from short sellers looking to profit.

At some point, a catalyst emerges that causes renewed buying interest and upward price momentum.

This catalyst can take a few common forms:

• Unexpected positive news, such as strong earnings results or an improved business outlook.
• The chatter in online forums fueling new investor interest.
• Technical trading signals indicate that the stock is oversold and due for a bounce.

When substantial new buying pressure enters the market for a heavily shorted stock, short sellers quickly find themselves facing losses as the share price rises. Many rush to exit their short trades by buying shares to cover their positions to mitigate increasing losses.

This wave of panicked short covering then feeds on itself. The aggressive buying by short sellers converting to long positions accelerates the upward trajectory of the stock price.

More short sellers scramble to cover their shorts as pain thresholds are crossed. A full-blown short squeeze ensues, with massive spikes in buying volume and rapid surges in the stock’s valuation.

Dynamics of a Short Squeeze

There are a few key dynamics that characterize a short squeeze:

What Causes a Short Squeeze?

Short squeezes tend to occur when a handful of key drivers occur simultaneously to push the price of a heavily shorted stock to the sky. Here’s a summary of what those catalysts usually are.

High Short Interest

The security needs to have an elevated short-interest ratio, indicating that traders have borrowed a significant number of shares to bet against the performance of the asset. \

The days-to-cover ratio should also be high, meaning it would require extensive buying to exit shorts based on the average daily volume of the financial instrument. The higher these metrics are, the more susceptible the asset could be to experience a short squeeze.

Bullish Catalyst or Events

There needs to be a spark or catalyst that sets things in motion, like positive news, retail investor enthusiasm, or technical signals enticing traders to buy. The news must be meaningful and have a dramatic impact on the outlook of the business, its fundamentals, or its strategic direction.

For example, a company that was expected to file for bankruptcy unexpectedly finds a lender or secures a deal that allows it to stay afloat. That can prompt a short squeeze if short interest was high prior to the announcement.

Buying Frenzy

A self-perpetuating process ensues as short-covering leads to more covering, causing a snowball effect amidst the fear of missing out, also known as FOMO. This drives panic buying.

Panic buying shoots the price to sky-high levels as sellers keep asking for higher and higher valuations, and buyers, in this case, the short sellers, are forced to raise their bids to close their positions and limit their losses.

Limited Float / Supply Imbalance

A smaller public float and limited liquidity usually exacerbate volatility and squeeze dynamics by constraining supply. Brokers also tend to raise their fees for borrowing the stock as the instrument is scarce.

The exact mix of factors varies across different short squeezes but tends to involve at least a few of these key ingredients. Fundamentally, significant short interest appears to be an ever-present factor whenever a short squeeze has occurred.

Examples of Epic Historic Short Squeezes

Several notable short squeezes have happened throughout the last two decades, the three most prominent ones involving the shares of Volkswagen, GameStop, and Tesla.

Volkswagen (2008)

The Volkswagen short squeeze of 2008 is perhaps the most extreme short squeeze ever.

Volkswagen briefly became the world’s most valuable company as its share price soared from €210 to almost €1,000 intraday. Losses for short sellers totaled over $30 billion, according to some estimates.

Porsche cornering the market by buying over 70% of Volkswagen’s shares triggered massive short covering during this incident once the company disclosed its stake.

GameStop (2021)

In 2021, the video game retailer GameStop was the epicenter of a historic retail-investor-driven short squeeze.

GameStop shares surged from around $20 to an intraday high of $483 as short sellers scrambled to cover their positions in the midst of the buying frenzy fueled by the comments of a handful of users within the popular Reddit forum WallStreetBets.

GameStop, along with other heavily shorted stocks back then, were deemed ‘meme stocks‘ as investors used funny imagery to describe what was happening and communicate with each other via the forum.

Melvin Capital and other hedge funds suffered multi-billion dollar losses as a result of this incident.

In addition, brokerage firms were forced to impose buying halts for GameStop’s stocks and options to reduce the buying pressure. This move was widely unpopular and resulted in a probe carried out by Congress to analyze the incident and determine if consumers were unfairly stripped of their rights to trade their assets despite the circumstances.

Tesla (2020)

While more gradual than other blow-up short squeezes, Tesla‘s share price has climbed over 15X since 2019, partly fueled by repeated short covering.

The stock rose over 700% in 2020 alone as short sellers ultimately capitulated as the company lived up to its expectations of becoming a dominant force in the up-and-coming electric vehicle market.

The positive performance of the business ultimately favored those who had long positions as the market embraced Tesla’s success, and most of the discrediting that went on prior to that faded.

The Bottom Line

Short squeezes occur when those betting against a stock are trapped in their position and scramble to close them as buying activity intensifies.

While the conditions and catalysts that prompt them may vary from one case to the other, the forced unwinding of short positions triggers positive feedback loops leading to epic, yet often waning, stock rallies.