What is a Short Squeeze?

last updated

What is a short squeeze, why does it matter, and how you can profit (or lose) from one.

In the basic view of the stock market, you have buyers and sellers. When a buyer wants to buy, they find a willing seller, negotiate a price, and let money and stock change hands.

It's easy to understand a buyer's motivations: they like the stock and think it will produce value for them, whether by providing regular dividends, increasing in price, or both.

What happens when someone believes a stock will go down in price?

Short Selling is Betting Against a Stock

Suppose it's winter in Canada, and you're sure there's no market for iced lemonade until the spring thaws. You might think that the hot new IPO for Frozen Lemonade Slush, Inc isn't worth the money. In fact, you believe the company will lose money year over year with all of its kiosks on the road between Canmore and Banff.

In a short sale, you can "borrow" shares of the Slush company via your broker, sell them at the current price, and keep the proceeds until you buy them back (presumably at a lower price). This short selling is profitable for you if indeed the price of the stock goes down. You'll have to pay market price to buy them back, but your profit will be whatever you keep as the difference between the two prices.

Short sellers have a lot of risk in this situation. Selling the Slush company at $10 per share is great if the price drops to $9 or $1 per share. What happens if the price goes up?

In theory, short sellers are exposed to infinite losses. Short selling 1000 shares at $10 per share nets $10,000. If the price goes up—not down—to $20 per share, buying back those short shares (covering the short position) will cost $20,000. That's twice the original investment.

Worse yet, short sellers may pay interest on their shares until they close their short positions. You can't wait forever to buy back those shares, at least not for free.

How Many Shorts are Out There?

The number of shares shorted for any particular stock may be important. At the time of this writing, healthy, big stock like Coca-Cola has over 4 billion shares outstanding and a few million shares shorted. That means a few people think Coca-Cola will drop its share value.

Also at the time of this writing, a company like GameStop has about 70 million shares outstanding and around 62 million shares shorted. That means a lot of people thought the GameStop stock price would drop in value.

The short interest ratio compares the number of shares shorted to the number of outstanding shares. This number can hide a lot of details. If the number changes suddenly, that's a good indicator the stock market has changed its mind about the company's future.

What's a good short interest number? That depends on what you want to achieve. Anything under 10 or 20% probably indicates a healthy view of the company. A number at or above 50% suggests that there are a lot of short sellers with a large number of shares shorted of the stock.

Can the short interest ever exceed 100%? Yes. That's a little scary, but it can also be the sign of a good opportunity.

When are the Borrowed Shares Due Back?

Short sellers eventually need to cover their shorts. That means buying back shares from people willing to sell.

This can be trickier than it sounds.

The days to cover metric divides the number of outstanding shorts by the average daily trading volume. If the Slush company has 10,000 shorts and the average number of shares traded daily is 2,000, it'll take at least 5 days of normal trading activity to cover all of those shorts.

This where the short squeeze opportunity comes in.

Identifying a Short Squeeze

What happens when you're a short seller and you see the stock price creeping up and up and up? The higher it goes, the more you can lose, and your loss isn't capped, so you could lose everything.

What will you do?

You'll have to start buying. Ironically, this is likely to drive the share price higher and higher.

What happens when there are a lot of short sellers and a lot of shares sold short?

That's more people trying to buy with more transactions.

What happens when there aren't a lot of shares sold every day? The days to cover number goes up.

A short seller who wants to cover might have to raise their bid price to reduce further losses. If you've bought the stock outright, you'll see the price of your investment go up and up. That's profit for you.

In this short squeeze, people who've bought and held make money and people who shorted get squeezed. It's a game of chicken.

How do you find potential short squeezes? They lurk in stocks with several characteristics:

  • High short interest (high number of stocks shorted compared to total number of shares outstanding)
  • High days to cover (high number of stocks shorted compared to average daily volume of shares traded)
  • Enough investor sentiment so that the stock price will rise

Easier said than done, right? For the GameStop short squeeze of 2020/2021, it took a subreddit full of millions of retail investors (and whoever else is there) working for a month to identify, exacerbate, and profit from this heavily shorted opportunity. A similar short squeeze happened to Volkswagen.

These are dramatic examples. A smaller short squeeze might not make the news, even if it does make bulls a few tens of thousands of dollars.

There are some elements of more detailed technical analysis devoted to finding and exploiting these situations, but this combination of fundamental analysis (investor sentiment, underlying value) and technical analysis (number of shares in each category, ability to close a short position) is sufficient as a first filter.

Should a Short Squeeze Be Part of Your Strategy?

Value investors shouldn't shy away from a short squeeze opportunity, if they come across one.

While short selling may be anathema to a buy and hold investor, they're a fact of life in the stock market. Undervalued stocks may have been battered by short sellers, and so the short interest ratio may be high for good stocks with solid businesses.

In that case, a savvy value investor can buy a long position in a heavily shorted company and watch carefully for a short squeeze to form. Remember though that the renewed interest and increased price isn't necessarily due to the strength of the business (and in the case of the GameStop or Volkswagen short squeezes, the tenbagger returns are due to the short squeezes themselves). In that case, there's no shame in taking a nice profit and finding another undervalued gem elsewhere.

Investing During the Coronavirus Pandemic | How to Invest in Dogecoin