The stock market is a fickle system, isn’t it? At any moment, a stock can either increase in price and value or drop dramatically. Some may find this exhilarating because of the unpredictability of it all. Others do not agree and find the volatile nature of the market to be stressful. Whatever category you place yourself into, we can all agree that it is a two-way street. With stocks being just as likely to fall as they are to rise, many investors take advantage of this. However, by doing this, there is a high probability of them encountering the infamous ‘short squeeze’. Many investors – particularly novices – wonder if they should be afraid of it or if they should embrace it. There certainly is a notoriety that surrounds it, making it such an infamous concept. But what exactly is it? Moreover, is it worth being fearful of?

What does it mean?

A short squeeze is a recurring event in investments and finances. It occurs whenever a stock or another type of asset jumps sharply higher. This, in turn, forces traders who were betting that its price would fall to buy it. In doing so, they will forestall any greater losses. Their mad dash to buy only adds additional strain to the upward pressure concerning the stock’s price.

The role of short-sellers is to borrow shares of an asset that they believe will drop in price. This way, they will be able to buy them after they fall. If they turn out to be right, then they will return the shares. Furthermore, they will pocket the difference between the price from their initiation of the short and the actual sale price. If they turn out to be wrong, then they have no choice but to buy at a higher price. Additionally, they will need to pay the difference between the price they set and its sale price.

The mechanics of a short sale

Each and every short sale, as you could imagine, has an expiration date. Therefore, when a stock suddenly increases in price, the short-sellers will likely need to act fast. If they are lucky, they will be able to limit their losses. The stock price can make a huge spike as short-sellers decide to close their positions. They do this because they believe that the stock can go even higher. This is a stark contrast to their initial assumption when they first shorted, believing it would drop.

The more who choose to cut their losses and buy in order to cover their shorts, the bigger the squeeze will be. The factor that triggers this is typically a positive development, particularly on Fridays. To elaborate, it is when people do not want to be short going into the weekend when the market closes. Any positive news has the ability to spike the stock, even more, come the following Monday.

Tesla example

The flight of short-sellers and their impact on the price of a stock is what we recognize as being a short squeeze. In essence, short-sellers are being squeezed out of their positions, oftentimes at a loss.

Generally speaking, short-sellers concentrate on a stock that they think the market is overvaluing. Let’s use the Tesla company as an example. They were able to capture the enthusiasm of an array of investors with its innovative system. The main draw was their approach to producing and marketing electric vehicles. In the midst of this excitement, investors would respond by betting heavily on its potential. The response of short-sellers, meanwhile, was to bet heavily on its failure.

In the early months of this year, Tesla would become the most-shorted stock on the U.S. exchanges. Over 18% of its outstanding stock was in short positions.

In late 2019 and during early 2020, Tesla stock would go on to soar by roughly 400%. Needless to say, short-sellers got hammered. Altogether, they would lose approximately $8 billion. It wasn’t until early March 2020 that Tesla’s stock would finally fall. They were not the only ones; plenty of other stocks would drop, as well. This was thanks to a market downturn, an unfortunate outcome of the COVID-19 outbreak. As a result, short-sellers would make about $50 billion in a sell-off that lasted a few days.

Short Position

A ‘short position’ basically means that you are predicting a significant drop in the price of a stock. Specifically, over a given period of time. It is an ideal way to assist in making money, regardless of the stock price should go down.

Some people don’t like shorting; in fact, there are some that downright hate it. The reason for this dislike is, theoretically, there is no limit to the risks. Should the stock defy your forecast and instead rise, you will be unable to exit your position. That is, not until your losses add up substantially.

Whenever you short a stock, you effectively borrow shares within a given stock from your broker. Moreover, you do so at a specific price. Afterward, you purchase the stock at a later date and for a lower price. This is a method that will sell the stock before you buy it, which admittedly might appear backward.

Here is a basic timeline of how it looks:

1. You borrow stocks from your investor at whatever the current price is.
2. The broker sells the stock on the market and, in turn, will pocket the eventual profit.
3. When the stock drops in price, you will buy the stocks and return the ones you were borrowing.
4. You will be able to keep the difference in price.

Even if you are someone who does not like short selling, it is still something that is worth learning about it. It is a good nugget of knowledge that covers this recurring catalyst that could significantly spike a stock.

How it happens

To repeat an earlier point, short-sellers open positions primarily on stocks that they think will decline in price. No matter how sound their reasoning may be, it can easily be upended by a variety of things. That could be a positive news story, a product announcement, or even an earnings beat that piques the buyers’ curiosity.

The turnaround in the stock’s fortunes will in all likelihood prove to be a temporary occurrence. If it turns out not to be, then the short seller could face runaway losses as their positions’ expiration date approaches. For the most part, they opt to sell out immediately, even if it means being subject to a tremendous loss.

This is where the short squeeze comes into play. Every buying transaction by a short seller will lead to the price going higher. This will, in turn, force another short seller to buy.

Measuring interest

There are two measures that are incredibly useful for the identification of stocks at risk of a short squeeze. They are ‘short interest’ and the ‘short-interest ratio’.

Short interest is the total number of shares that sell short as a percentage of total shares outstanding. The 18% short interest of Tesla, for example, was extremely high. The short-interest ratio is the total number of shares that sell short divided by the stock’s average daily trading volume. Speculative stocks have a tendency to possess a higher short interest than that of more stable companies.

Keeping an eye on short interest can tell you about whether or not investor sentiment concerning a company is changing. Let’s use a stock that typically has a 15% to 30% short interest as an example. Any move above or below that range could indicate that investors are shifting their overall view of the company. Fewer short shares may imply that the rising price is going too high too quickly. Alternatively, the short-sellers are leaving the stock due to its becoming way too stable.

Any sort of rising in short interest above the norm is indicative of investors gradually becoming more bearish. Be that as it may, an extremely high reading could also signify an incoming short squeeze. This, as a result, could force the price to go higher.

Long squeeze: what’s the difference?

Short squeezes are a popular name in the stock market, but very few are aware of long squeezes. Involving a single stock or another asset, this particular squeeze occurs when a sudden drop in price incites further selling. In turn, it pressures long holders of the stock into selling their shares in order to protect against a huge loss.

Living in the shadow of short squeeze’s popularity, long squeezes can mostly be found in smaller, more illiquid stocks. This is where a few persistent or panicking shareholders can create baseless price volatility within a short time period.

A long squeeze has the capacity to occur in almost any market. However, they appear more dramatic in markets of low liquidity. Liquidity plays a significant role, as well as technicals and supply and demand. A stock that is continuously running aggressively higher gradually becomes more susceptible to a long squeeze. This is especially true in the case of the volume being very high when the price suddenly turns lower. All of the people who bought near the top will start to exit in droves should the price decline substantially.

There are a lot of people who simply can’t afford to hang onto the loss. And this is regardless if they believe that the price will return to current levels – or higher – following the decline.

Signs of a potential squeeze

Back in 2012, there was a 50%+ surge in the stock of Barnes & Noble. This increase was partially the result of a short squeeze. Microsoft’s investment in the bookselling company – which could be as much as $605 million – was definitely a trigger.

Using this example, we will go over the key signs that a stock may be vulnerable to a short squeeze.

1 – A tight float

The float is basically the percentage of a company’s stock that is tradeable on the market. When it comes to certain companies, it is a small amount because big shareholders usually have major stakes. This, in particular, was the case with Barnes & Noble. The eventual outcome was the shorts having an extremely hard time finding shares to cover their positions. Specifically, when the stock price suddenly spiked.

So, what is the best way to spot this? Well, a short seller is able to measure the tightness of the float. This is achievable by way of comparing the company’s short interest to the float. To elaborate, the short interest is the number of shares that are shorted. The ratio for Barnes & Noble was 67%, which should have been an obvious red flag. It is important to remember that a ratio of 10% or higher is a considerably dangerous level.

2 – Ample time to cover the short interest

You are able to calculate this by simply dividing the short interest by the average daily volume. This will effectively show just how long it will take for short sellers to properly cover their positions. In the case of Barnes & Noble, it was a total of 10 days. Keep in mind that five days should be an overt warning signal.

3 – Shareholders that double as activists

These are investors who are highly sophisticated and agitate for change, focusing on increasing the stock price. Most of the time, this is done by utilizing the proxy system in order to officially replace board members. Generally speaking, activist shareholders have a talent in setting off short squeezes.

Let’s take a look at Barnes & Noble. With them, there do appear to be some affluent activist investors. One of them is Jana Partners, which has a past of taking on disruptive roles at other companies, like McGraw-Hill. In those cases, it was successful in agitating for the publisher to divide itself into two separate companies. An additional noteworthy Barnes & Noble holder is Liberty Media. Their management team has a long and impressive history of unleashing shareholder value. The CEO of this company, Greg Maffei, was once the chief financial officer of Microsoft.

Why try it?

After all that has been said, is it worth giving short squeeze trading a try? Well, for starters, a short squeeze has the potential to produce great outcomes. This is especially true if you are currently holding a long position.

Let’s imagine that you are looking at a company that is fundamentally flawed. It has terrible management policies, poor sales, and no adequate funding. Put simply, it is a trainwreck. However, it is arguably one of the best short-squeeze opportunities that you could ever imagine. Let’s take it a step further and say that the company makes an announcement out of the blue. The stock price will go from single digits to $100+ per share in a matter of a few days.

You are in a position to potentially profit from the short-sellers in this particular situation. They all made predictions of a drop in stock price because that was where the company was heading. Now, though, the price is shooting up. Moreover, short-sellers are starting to exit their positions at a rapid rate and buying to cover.

And the one who will profit from those exiting their short positions could very well be you.

What this means is there are stocks that possess plenty of short-sellers who may need to cover themselves someday. Realistically, there is no such thing as 100% accurate or real-time short-selling data. This is an incredibly imperfect science, after all. A common recommendation is to use short data from StocksToTrade, which is quite accurate in comparison to other platforms.

All in all, it is possible to bet against the short sellers and win. Furthermore, it is not as risky as short selling itself. Be that as it may, it is also difficult to judge which short squeezes will go supernova.

Something else to remember

Of course, going long is usually less risky than short-selling. This is because shorting typically involves margin and borrowing shares on a stock that could potentially surpass your initial investment. There’s a chance that you could lose more money that is not even yours to begin with. And this is due to you borrowing it with margin.

With that in mind, suppose you are holding a short position, and the price skyrockets. If this happens, then you will want to leave as soon as possible. Be sure to remember rule number one: always cut losses quickly. This is especially crucial as a short seller.

A large number of people/traders/funds exiting their short positions has the potential to push the price up faster and higher. This will effectively squeeze all the other short sellers into doing the same as panic sets in. Moreover, as more traders scramble to minimize losses. The result is the creation of ginormous squeezes.

There is one other important thing to remember about short squeezes. They are more likely to occur in stocks that have both small market capitalization and a small public float.