Short Squeezes ☑️ Explained for Dummies

What is a short squeeze? 

A short squeeze refers to an occurrence in financial markets when a sharp and rapid rise of a financial instrument (such as a stock or other tradable security) compels traders with short positions to exit their positions as swiftly as possible in order to mitigate their losses. 

A short squeeze is typically characterised by strong buying pressure that ‘squeezes’ short sellers out of their trading positions. 

Short sellers are traders who use short-selling, also referred to as shorting, as a trading strategy. Short selling occurs when a trader borrows shares of a stock with the expectation that they will decline in price, in order to buy them later at a reduced price.  

If the assumption of the trader is correct, the shares are returned to the owner of the shares, and the trader collects the difference between the price when his/her short position was initiated and the price when the trader buys the shares back to close out his/her short position. 

However, if short selling goes wrong, short sellers are obliged to buy at a higher price and pay the difference between the price they specified and the increased sale price. This means that a short seller incurs a loss on his/her trade.  

Short squeezes usually occur in stock markets. Although they can also develop in other financial markets. 

The unfolding of a short squeeze 

A short squeeze usually starts to unfold after the price of a stock has declined over a period of time. The drop in price persuades more short sellers to take short positions on the stock in order to generate a profit from the drop in price.  

At some stage, substantial buying pressure starts to enter the financial market. The buying pressure can be caused by various factors, such as: 

• A technical analysis indicates that a stock is oversold, persuading technical traders to start buying the shares because the price of the shares is possibly ready to move in an upward direction. 
• Unforeseen good news about a company, such as an encouraging earnings report, exceeds the predictions of market analysts by far. 
• A gradual build-up of buying pressure that starts to outweigh the selling pressure in a financial market. 

When the new buying pressure in the market escalates to a point where it starts to push the price of a stock sharply higher, short sellers experience that their profitable positions start to change into losing positions, eroding their profits, or even worse, causing them to incur trading losses. 

Short sellers begin to exit their trading positions which brings more buying pressure in the particular market, causing the price to move upward. Subsequently, more short sellers are forced to cover their positions.  

Also, the buying pressure attracts more buyers, driving the price of the shares to higher levels. The combination of new buyers and anxious and nervous short sellers leads to a fast increase in price that can be exceptional, which compounds the consequence of the short squeeze. 

In some cases, when the effect of the short squeeze fades away, demand for the shares drops, pushing the price downward – oftentimes almost as fast as it increased. 

How to identify a looming short squeeze 

There are various ways that traders can use to identify a looming short squeeze. Ways or measures such as: 

• Technical indicators such as the Relative Strength Index (RSI), which is used to indicate overbought or oversold conditions in a financial market. When a stock or other security is regarded as oversold, the expectation is that the price will increase. When the RSI reading of an asset is less than 20, it is considered as oversold. 
• Short interest refers to the percentage of a stock’s total number of shares that are currently sold short. When short interest is significantly higher than the normal level, it is an indication that traders have become more bearish, with the chance of a short squeeze likely to occur. Speculative shares of companies tend to have higher short interest than shares of more steady companies. 
• Short interest ratio, also called ‘days to cover,’ refers to the total number of shares currently held by short sellers divided by the stock’s average daily trading volume. The calculation denotes the number of days (theoretical) – considering average trading volume -that it will take for short sellers to exit all their trading positions. The higher the number of days to cover, the more likely the stock will be subjected to a short squeeze. 

Risks of trading short squeezes 

Risks involved in the trading of short squeezes include, amongst others: 

• There are numerous examples of stocks of companies that increased to higher price levels after they experienced a considerable short interest. Contrarily, there are many stocks of companies that were subjected to significant short selling, that subsequently keep dropping in price.
• A heavy short interest does not necessarily imply that the price of a stock will increase. On the contrary, numerous traders expect it will fall. A trader who buys in the hope that a short squeeze will occur should have better grounds to expect that the price of the stock will rise.
• Traders (and speculators) who have short positions in a financial instrument can suffer extreme losses if the financial instrument undergoes a short squeeze. Contrarily, investors who have accumulated long positions in financial instruments, anticipating a short squeeze, will benefit as the security price rises.

Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, reputed, and regulated broker before making trading and investment decisions.