What Is A Short Squeeze?

The average person might have a basic understanding of the stock market that’s served them pretty well up to this point in their lives. At its most basic, the stock market is all about buying or selling the shares in a publicly traded company.

However, the early months of 2021 have brought a whole new set of terms to learn. We’ll get into what a short squeeze is, how it works, whether they can be identified beforehand and what to consider. Finally, we’ll look at protecting your finances.

What Are Short Squeeze Stocks?

For a baseball fan like me, a short squeeze might be a lightly tapped bunt that’s just good enough to get the run in from third base. However, when applied to the stock market, the term short squeeze has an entirely different meaning:

A short squeeze occurs when traders are forced to quickly buy the stocks they had initially bet would fall when the price instead rises dramatically in order to avoid further losses. This spike in the price causes a squeeze in the market as further pressure is added to the stock.

Not every stock that goes up when others bet it might go down results in a short squeeze. You have to get a substantial increase in the price of the stock to make the biggest difference and start perpetuating further upward movement. The reason for this has to do with the mechanics of how short selling actually works.

How A Short Squeeze Happens

You can't understand what happens in a short squeeze without first understanding short selling. When you short sell a stock, you're selling a stock that you don't actually own, with the hope that the price of the stock goes down so you can buy it back at a later date, thereby making money by betting against the stock.

Of course, you can’t sell a stock you don’t own right away. In order to do that, you need to work with a broker or online brokerage in order to find a stock to borrow so that you can sell it. To borrow stock, you have to have an account that allows you to trade on margin. This is where the potential for a short squeeze happens.

The Squeeze

When you trade on margin, you’ll need to put up some of your own money as an initial margin. The amount is based on the current share price of the stock or stocks being shorted as well as the number of shares being borrowed by your broker for sale. The percentage that you have to put up for an initial margin will vary by brokerage.

Once the shares are sold, the money is credited to your account. However, it’s not yours until you buy the shares back. In between the time the shares are sold and when you buy them back, you have to maintain a certain margin in your account. If the share price rises enough that the margin in your account doesn’t cover the amount you would lose on your short by selling at that moment, your broker can subject you to a margin call. In a margin call, the brokerage may or may not give you a certain amount of time to put in more money to get back to the required margin. The agreement likely gives them the option of closing your short position to cover losses.

If covering the short doesn’t cover your losses or you don’t put up the margin required in the event that you’re given time after the margin call, the broker may have options, including coming after other funds and assets you have to make up for the losses.

If one or two traders with a small short bet decide to cover their positions to limit losses, the price of the stock could rise a little bit, but what really creates upward price pressure for a stock is when traders with big positions in a particular short decided to cut their losses.

If these bigger fish buy a bunch of shares at once, that has the potential to push the stock price higher in a more significant way. If that happens, the price can quickly push up as people either scramble to cover their positions on their own or are forced to do so based on falling below the margin requirement in their brokerage contract. Then you have a short squeeze.

Can You Predict It?

The next question that probably occurs to many is whether any of this follows a predictable pattern. After all, if you can predict a short squeeze, you might be able to get in on a stock that's about to rise to an indefinite level.

However, predicting the future is hard. All you have to go on is the past, which every investment advisor or their lawyer should tell you isn't a guarantee of future performance.

One thing that caught the eye of some shrewd traders who were looking for a stock to short most recently were the sheer number of investors who had short positions in GameStop stock.

If you find a stock with heavy amounts of short positions and you can convince enough people to go along with you in buying the stock, you can push the price up, making more and more traders cover their positions, which can lead to a short squeeze. Typically, analyzing the number of short positions and things like average daily trading volume would be the province of professional investors and people who love numbers analysis.

In the case of the GameStop short squeeze, it got a boost from a Reddit forum dedicated to investing. The message was shared and continued to be amplified there, driving more and more traders into the frenzy of trying to drive the stock higher to stick it to those who had short positions. Sometimes the source of information about the next short squeeze comes from the strangest places.

Identifying Potential Short Squeeze Stocks Before It Happens

Before we go into this, I should state that the things we're about to go over require you to be paying really close attention to particular stocks. It takes a special type of person to want to really dig into statistical analysis and watch the market all day long.

Second, you’ve got to get very lucky. Just because something is primed for a short squeeze according to so-called experts doesn’t mean it’s going to happen. There is no guarantee that any of these things will work out for you, but these are some of the things that investors tend to look at when identifying potential short squeezes.

• Relative strength index: The relative strength index is intended to determine how much a stock might be overbought or oversold. Essentially, this is determined by looking at the average gain or average loss over a specific period of time, usually 14 trading days. The formula is a bit complicated and involves a multistep fraction, but a number of 30 or lower is thought to mean that a stock is undervalued. If it’s 70 or higher, people who subscribe to this metric would say the stock might be overbought.
• Short interest: Short interest has to do with how much of your stock is being shorted. In theory, the higher this number the greater the squeeze potential.
• Average daily trading volume: The average daily trading volume gives you an idea of how long it would take for someone to unwind their trading position, whether they’re following traditional investment strategy to buy low and sell high or reversing it by selling high and buying low as you would in a short position. For example, a company might have 100,000 shares sold, but only 10,000 shares are sold on a daily basis. The trading volume is combined with short interest to give those interested in short squeezes a key piece of information. If you had an investor with 30,000 shares being sold short, it would take them 3 days to unwind that position when they decided to get out based on average trading volume. During that time, those participating in the short squeeze could try to drive the price up.
• Number of shares sold short compared to total outstanding shares: The higher this ratio is, the bigger the potential target something is for a short squeeze in the minds of many investors.

Many of these numbers are available for any particular publicly traded stock you want to find. However, there is a certain amount of mysticism in any one number that investors swear by.

What To Consider Before Using Short Squeeze Stocks To Your Advantage

Before you go all in with short squeezes and incorporate them as a major part of your investment strategy, consider the fact that it's extremely risky for multiple reasons. You need to decide for yourself whether the risk is worth the reward. Among the risk factors are the following:

• Long-position traders can be benefited: Those hyping up a particular trade might be investors looking to sell high who want to pump up their stock returns. There’s nothing inherently wrong with this if other people participating in the short squeeze can also benefit, but no one will benefit more than whoever is in the earliest. It’s a bit like a Ponzi scheme in that those that get in later won’t do as well and have a high risk of losing on the deal.
• The timing has to be right: If you get in on a short squeeze, you have to time it right to know when to get out. Eventually, there are only so many shorts to cover. The trouble is that knowing exactly how high a stock price can go is incredibly hard to judge. Kenny Rogers said that you need to know when to hold ‘em and know when to fold ‘em, but he was referring to poker where at least you know what your cards are. With the stock market, you have no control over what other traders might do, so there’s even more struggle.
• Stocks are volatile: Stocks move up and down for seemingly no reason at all at times because people occasionally rely on emotion more than rationality.

Protecting Your Finances

There are several risks associated with participating in a short squeeze.

• The squeeze never happens. The first risk is that you get in on a squeeze that never actually happens. If you get in and the price the stock keeps going down, you haven’t accomplished your goal. That said, you can always hold on to the stock hoping the price goes back up.
• You get the timing wrong. You never want to be at the tail end of the squeeze right before the share price comes back to earth. In that case, you’re the one that loses money. Even if you make money on the short squeeze, you can give up a certain amount of return if you mistime the sale and catch it on the way down.

Because short squeezes are risky one of the ways you can reduce your exposure is to continue making smart investments in other areas. Lots of investors don’t have a ton of experience, so before undertaking any investing strategy, it’s never a bad idea to speak with a financial advisor.

If you do decide to undertake a short squeeze strategy as part of your portfolio, there are some things you can do to limit the risk. These include putting in buy limit orders where you don’t purchase a stock once it goes above a certain price. A stoploss order means that you can set your brokerage account to sell once it reaches a certain price. In this way, you can protect any profit you might take. This also prevents you from having to watch the market like a hawk.

It’s important to note however that this is certainly a risky investing strategy. It’s not something the normal investor should go into blindly. Be aware of your tolerance for risk. Make sure you know what you’re getting into and don’t hesitate to talk to someone.

The Bottom Line: Should You Invest In Short Squeeze Stocks?

Participating in a short squeeze is an investment strategy under which a stock is bought up in large numbers to drive the price higher when other traders expect the stock price to fall. When they have to cover their position to cut their losses, this pushes the stock price up even further because there is more demand to buy.

It’s a risky strategy for a couple of reasons. First, unless you have a lot of money to take a bet on the opposite side of the short, you’ll need to recruit plenty of other investors to also put their money toward the same stock purchases in order to make a meaningful difference in the stock price.

Secondly, even if you get the short squeeze going, it’s hard to know when all of the shorts will be covered and the upward momentum in a stock is going to cease. The timing is both crucial and incredibly difficult to predict.

Additionally, although there are things that investors might do to predict the next reliable short squeeze target, no one can say for sure whether a short squeeze is going to gain any traction. It’s very possible for the stock price to go down rather than up.

A short squeeze is a very risky strategy. You should consider speaking with a financial advisor and developing a full financial wellness plan before moving forward with any investment options. They’ll be able to help you tailor something for your personal finances.