What is a short squeeze? Understanding why they happen and how they work

By the end of the 2020, the heavily shorted stock caught the attention of an aggressive group of day traders from the /r/wallstreetbets community on the social platform Reddit. The online community realized that if they collectively and heavily bought GameStop https://traderoom.info/ stock, they could deal a huge blow to the hedge funds who were shorting the stock, and they could earn a profit along the way. For many of these investors, a profit wasn’t even their main goal — merely “sticking it to the man” would be enough.

The first phase of short selling is to sell the stock, and the second phase (which is mandatory) is to buy the borrowed stock back to return the stock to its original owner. Tactics like setting stop-loss orders, which essentially instruct a broker to sell a stock once it reaches a certain value or maintaining a diversified portfolio can help mitigate risks. Proactively staying informed can also shield investors from the risks of short selling and possibly leverage market volatility to their benefit.

  1. However, there was very little supply (shares to buy), which affected short sellers’ ability to close their positions.
  2. There are no guarantees that working with an adviser will yield positive returns.
  3. This caused panic among the short sellers, who now realized that a very limited number of shares were available to close out their positions.
  4. The next day the stock hit a high of almost 160 with similar action the next day.

The higher the short interest percentage increases, the more likely a stock can be prone to a short squeeze. As mentioned above, short sellers believe that there will be a decrease in a stock’s or security’s price. If the short seller’s prediction is correct, they will profit by pocketing the difference between the price they sold the stock for and the price they bought it back for. However, if the short seller is incorrect, they run the risk of losing a substantial amount of money and may hurry to front the cost of the increased stock price to exit the position.

Just getting started with stocks?

Short sellers must buy additional shares of stocks to cover their short positions, and this frantic buying leads to a surge of additional frantic buying. Speculators looking to profit at the short sellers’ expense often add fuel to the fire. Regardless of a stock’s performance and whether or not it performs well, the short seller will always have to return the borrowed stock to their broker. The short seller can pocket a profit from using this strategy, but the losses that can be accrued from this may outweigh the potential gains. It’s important to understand the risks with any investment strategy, but most importantly, how short and long positions in stocks can be a benefit or detriment to your investment portfolio. The short interest ratio shows the average number of days needed to exit a short position.

Where Can I Find Information on Stocks with High Short Interest?

Typically, short sellers (those who have borrowed and sold stocks they believed would fall in value) scramble to buy them back as the prices start rising, contributing to further price hikes. Understanding the dynamics of a short squeeze, its importance, and the inherent risks involved is fundamental for any investor involved in trading. In situations like these, a financial advisor could provide practical understanding and advice in navigating short squeezes for both novice and experienced investors.

Our Services

This phenomenon creates a constant spiral effect of buyers purchasing ABC stock because of its good performance and short sellers purchasing ABC stock to exit the position and cut their losses. The result in this example is a short squeeze, or a rapid increase in ABC stock that causes short sellers to get squeezed out of their positions. In short trading, the main risk lies in the potential for unlimited losses, as a stock’s price can rise indefinitely, and a short seller’s losses grow as the price continues to increase. This risk intensifies during a short squeeze, where the stock’s price can skyrocket for a brief period. However, with an understanding of these potential risks, working with a professional can be crucial in formulating an effective risk management strategy in such circumstances. This buying may proceed automatically, for example if the short sellers had previously placed stop-loss orders with their brokers to prepare for this possibility.

When many short sellers attempt to buy back simultaneously, there is no cap on how high stock prices may rise. This often gives rise to opportunistic investors trying to capitalize on the short squeeze by buying during the price ascension. A short squeeze is bad news for short sellers and good news for investors going long. The “squeeze” forces short sellers to buy, raising the price of the stock, which causes them to lose money.

These short squeezes were ranked keeping in mind the amount of money involved, the profiles of the individuals involved, and their overall effect on the market. However, it’s important to note that the business landscape is filled with unexpected developments and turnaround stories. For a highly shorted instaforex review stock, if there is any positive news regarding the stock’s future, it can boost demand for the stock and ignite a short squeeze. This article will outline the foundational concepts of the short squeeze while providing insight on how to manage and trade around this contentious financial market phenomena.

Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Yet, over the past five days, the stock has gained more than 26%. Plug investors might view this sudden surge as potentially a dead cat bounce, rather than a definitive trend. According to the Securities and Exchange Commission short selling is illegal as the law states.

Free Online Investing Workshop

In early 2020, Tesla was the most-shorted stock on the U.S. exchanges, with more than 18% of its outstanding stock in short positions. This caused panic among the short sellers, who now realized that a very limited number of shares were available to close out their positions. The short sellers created a massive spike in demand for the stock, and over the span of a few days, the price of the stock soared more than 300%. Most are significant and result in rapid and astonishing price jumps. Short squeezes are usually short-lived, but even the briefest squeeze can cause huge losses for short sellers who are unable to close out their positions quickly. The chart below shows the relative price increase between Volkswagen AG and the German DAX index.

A low RSI means that a stock is oversold and is trading at a low price, while a high RSI means that a stock is overbought and is trading at a high price. An RSI below 30 means that the stock’s price will increase, which can signal a short squeeze. During that time, Volkswagen became one of the most valuable companies in the world as its share price increased to over EUR 1,005 per share or over $1,000 per share. Porsche benefited by reaping over $10 billion in profit, while short sellers lost billions of dollars over those couple of days.

Targets for short squeezes

However, Volkswagen’s stock peak eventually came to an end, falling by almost 60% in a few short days. As recently as September 2020, GameStop traded for less than $2 a share (split-adjusted). It slowly gathered momentum through the end of the year and started 2021 at more than $4 per share. Many investors thought the company was going broke and invested accordingly.

Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict
editorial integrity,
this post may contain references to products from our partners. Short selling is risky because it has limited upside, but unlimited downside.

This can cause the stock’s price to further increase, resulting in further action by short sellers. GameStop’s stock price surged due to a short squeeze on major hedge funds that were short the stock and forced to sell to cut losses. The stock price went from less than $5 a share to $325 in just a month. The flight of short sellers and their impact on a stock’s price are known as a short squeeze. Short sellers are being squeezed out of their positions, usually at a loss.

Leave a Reply

Your email address will not be published. Required fields are marked *