What Is A Short Squeeze? – Why Do They Happen And How Do They Generate Profit?

A short squeeze is a devilishly widespread phenomenon in the stock market, where a sharp rise in the price of an asset forces traders who previously sold short to close out their positions. The intense buying pressure “squeezes” the short-sellers out of the market.

When investors short a stock, they bet that its price will fall. A short squeeze happens when, instead, the price of a stock rises dramatically, causing investors to cover their positions. The same investors who bet against the stock propel the price higher and higher as they crawl to close their positions.

Let’s help you understand what is a short squeeze with a hypothetical example. Suppose an investor believes that shares of NoGood Co. are overvalued at their current share price of $100, then that investor can borrow someone else’s shares of NoGood and immediately sell them to another buyer — again, for $100. Of course, you can not simply sell what you do not own with no consequences that you might encounter at some point and must return those borrowed shares.

When that day comes, the investor needs to buy shares to return them to the lender. If the investor is correct and the share price declines, let’s say to $70, then the investor will make $30 in profit. They sold borrowed shares for $100, repurchased them for $70, returned the shares, and kept the difference. If the shares of NoGood Co. increase in price, then the short seller is at risk of losing a considerable amount of money on the trade.

This article will cover how a short squeeze works and shed light on lessons learned from past short squeezes. So, keep reading to grasp all the information you need to navigate your stock in the market.

What is a short squeeze in stocks?

A short squeeze of stock occurs when market prices rise rapidly beyond what analysts and market participants had expected. Short squeezes can hit investors who are shorting the market with borrowed stocks particularly hard because they could end up spending more money to rebuy and return the borrowed stock, commonly known as a short-covering, than they anticipated.

A rapid and unexpected surge in the price of an asset (mostly a stock) causes a short squeeze. Short sellers will seek to abandon their short positions as prices rise. This drives demand for the stocks to increase, which reduces supply. This shift in the supply-demand dynamic causes prices to increase further, compounding the short squeeze effect.

If investors are using a short-covering strategy with borrowed stock, they will need to buy back the shares which they have borrowed to open the short position before the expiration date arrives. The expiration date in a short cover is the date on which the borrower agrees to return the stock to the lender.

Short squeeze indicators

Short squeezes are notorious for unpredictably and taking a quick plunge. However, you can still figure out a short squeeze may be coming through the following indicators:

• A Substantial amount of buying pressure:

If you see a sudden rise in the overall number of shares bought, this could be a warning sign of a pending short squeeze.

• High short interest of 20% or above:

“Short interest” is the percentage of the total number of outstanding shares held by short-sellers. A high short interest percentage means many of all stock’s outstanding shares are being sold short. The higher the percentage, the more likely a short squeeze may be building.

• High Short Interest ratio (SIR) or days to cover above 10:

SIR is a comparison of short interest to average daily trading volume. It represents the theoretical number of days, given average trading volume, short-sellers would need to exit their positions. The higher this number, the more likely a short squeeze is coming.

• Relative Strength Index (RSI) below 30:

RSI indicates overbought or oversold conditions in the market on a scale of 0 to 100. A stock with a low RSI means it is oversold, trading at a very low price and possibly due to increasing; a high RSI indicates the stock is extremely overbought, trading at a high price, and possibly due to drop. Any RSI below 30 signals an imminent price rise, which could lead to a short squeeze. A company’s online stock listing usually includes its RSI, often under its Indicators section.

Short squeeze example

As several brokers involve themselves in short squeezing, there are ample examples of a short squeeze in stocks of different companies. For over a century, from Piggly Wiggly to GameStop, short squeezes have been causing drama on the stock markets. However, we will present you with a few significant examples.

1923: Piggly wiggly short squeeze

When Clarence Saunders opened the first Piggly Wiggly grocery store in Tennessee in 1916, it was a revelation. For the first time, customers could roam the aisles of a grocery store and pick out their products. Within six years, there were Piggly Wiggly stores all over the Southern and midwest regions of the US, and the New York Stock Exchange (NYSE) listed Piggly Wiggly stock. However, Clarence Saunders overplayed his hand.

After the market traders started to short Piggly Wiggly stock, Saunders vowed to hit back. Using his own money and $10 million from a group of bankers, he bought up all available Piggly Wiggly stock, pushing the stock price up by approximately 50%.

By March 1923, Saunders owned all but 1128 shares of the company’s outstanding shares, and he called on the short sellers to pay up. The following day, the NYSE suspended trading in the stock before permanently stopping all trading in Piggly Wiggly on 26 March. The suspension gave the short-sellers time to buy most of its 1128 outstanding shares and cover their positions.

Saunders ended up with complete control of Piggly Wiggly stocks, millions of dollars of debt, and no ability to sell his shares on the public market. He made an early attempt at crowdfunding by taking out ads in local papers saying that the failure of Piggly Wiggly would shame the whole South. But the campaign fizzled out, and Saunders had to turn over his stock and file for bankruptcy.

Gamestop short squeeze

In late January 2021, shares of a company called GameStop (GME) stock, which had been trading around $2.57 per share, suddenly shot up, eventually as high as $500, when users of the Reddit website subgroup of Wall Street Bets began buying up shares. This was not a piece of good news for short-sellers, who had bet the stock would keep falling.

Unlike most investors, who want their stocks to appreciate, short-sellers make money when stock prices go down and lose money when they go up. Thus, when GameStop started gaining, these short-sellers were caught in what you call a short squeeze. They had borrowed to support their gloom-written investment, and they now had to pay it back by buying GameStop shares at higher prices. Otherwise, they would have to hang on and risk losing even more money.

As of mid-July 2021, GME drifted around $185 per share. While most Markets Insider analysts have a Sell rating on the stock, it held up well on July 19, 2021, during a selloff sparked by an increasing number of cases of the delta COVID variant. Even then, GME closed up 2.6%.

Dryships

Another example of a short squeeze in stock is Dryship ($DRYS), which ran up over 2,000% following Trump winning the election. This stock was heavily shorted, but with the surprise win, shares were back in favor, and buyers drove the stock up, causing shorts to cover and the stock to shoot up. Shares were trading below $5 per share, but over the span of just 4 days, shares breached $100 per share.

2008: Volkswagen vs. porsche

Porsche and Volkswagen had a long story of working together when suddenly, on 26th October 2008, Porsche revealed that it had gained control over 74% of voting shares of Volkswagen by buying up the company’s almost all stock.

Amidst the global financial crisis in 2008, short-selling was at its peak. The Porsche-Volkswagen short squeeze was only possible because so much Volkswagen stock (approximately 12.5%) was on loan to short-sellers at the time of the Porsche announcement. When the market opened the following day, those short-sellers raced to exit their positions to minimize their losses, buying more stock and inflating the share price even more.

On 27 October 2008, Volkswagen’s shares opened at €348 and closed at €517 took a rise of almost 150%. The stock peaked at €999 per share by Tuesday, while short-selling costs were estimated to be in the tens of billions. Porsche’s chief executive officer (CEO) Wendelin Wiedeking received charges of market manipulation for his role in the short squeeze, but the charges were later dropped.

2020: Tesla stock price rally

In August 2020, Tesla’s shares surged, breaching the $300 mark for the first time in the company’s history. By month-end, the stock soared close to $450, leaving market pundits scratching their heads over the unexpected rally.

Reflecting on the frenzy, analysts pinpointed several catalysts propelling Tesla’s ascent. The rising popularity of electric vehicles, anticipation surrounding its inclusion in the S&P 500, and the announcement of a five-for-one stock split all played pivotal roles. This strategic move essentially rewarded early investors with four additional shares for every one purchased before August 21, 2020.

However, the true driving force behind this surge lay in the short squeeze phenomenon. By mid-2020, Tesla had garnered the dubious distinction of being the most shorted stock globally, reflecting Wall Street’s skepticism about its prospects. Contrary to expectations, the company enjoyed a string of favorable media coverage and consistently robust financial performances.

The repercussions for short sellers were staggering, with losses totaling a staggering $40 billion by year-end. What made Tesla’s short squeeze particularly noteworthy was its gradual yet relentless climb, inflicting sustained losses on short positions over several months.

In hindsight, the Tesla short squeeze stands out as one of the most impactful in history, underscoring the challenges faced by those betting against the tide of positive momentum.

How does a short squeeze happen?

Here is how a short squeeze scenario unfolds:

1. You identify a stock you believe is overvalued and take a short position. Borrowing and selling shares at today’s high price in anticipation the price will go down and you will be able to buy replacement shares at a much lower price.
2. Instead, something happens, causing the stock price to start going up. That “something” can be the company issuing a favorable earnings report, some sort of favorable news for its industry, or simply many other investors buying the stock as happened with GameStop.
3. You realize you are unable to buy the stock back at a low price. Instead of sinking, the stock price is climbing, and it exceeds the price you bought it for. At this point, you must either buy replacement shares at a higher price and pay back your broker at a loss, or buy even more shares than you need hoping that selling them for profit will help cover your losses.
4. All this increased buying causes the stock to keep going up. This forces even more short-sellers like yourself into a tighter vise. You have the same choices as above, only the stakes keep mounting, and so do your potential losses.

Protecting yourself against a short squeeze

There are specific actions you can take to try to protect yourself against a short squeeze or to at least alleviate its grip.

• Place stop-loss or buy-limit orders on your short positions to curb the damage. For example, if you short a stock at $50 per share, put in a buy-limit order at a certain percentage (5%, 10%, or whatever your comfort level is) above that amount. If the shares rise to that price, it will automatically trigger a purchase, closing out your position.
• Hedge your short position with a long position. You can also buy the stock (or an option to buy the stock) to take advantage of rising prices. This does mean, you are betting against yourself, in a way, but at least you lessen the damages of the losses and benefit from the price appreciation.

How does a short squeeze end?

The life of a short squeeze in stock is scarce. The main factor is that the rise of stock price generally happens due to the company’s short-term technical factors and long-term goals. If you have been reading this article from the top, you must have read in the short squeeze example of GameStop that human behavior and technical factors were the reasons behind the increase in stock prices.

The example clearly indicates that people stop buying shares and lock in the gains at some point. When all of the weak shorts are marginalized out of their position and the conditions for the short squeeze disappear, the force buying also ends. This leads the stock price to crash back down to earth.

When a short squeeze eventually loses its steam, the stock price usually declines by 50 per cent within the next three to four days.

Short squeeze stocks that could take off in the current quarter of 2022

Although a short squeeze is a risky business, it can yield huge profits. In the past year, short squeezes have accounted for some of the biggest headlines on Wall Street. Groups of online traders on Reddit and other social media platforms repeatedly arranged targeted buying campaigns in an attempt to trigger massive short squeezes in some of the market’s most heavily shorted stocks.

A short squeeze is a significant, short-term spike in a stock’s share price generated when a substantial number of short-sellers had to exit their positions at once by buying stock. Here are some potential short squeeze stocks to watch currently, according to market analysis firm Ortex Analytics.

View inc. (ticker: VIEW)

View designs sell smart windows that reduce energy consumption. The company went public via a merger with a special-purpose acquisition company in March 2021. Since the merger, the stock went down from around $9 to less than $3 per share as the market closed on January 31st.

In January, View said it will be issuing restated financial statements sometime in the first quarter, which is a potential short squeeze catalyst.

The company initially announced that it found material-based errors in its accounting in November 2021. Ortex estimates that about 40% of VIEW’s float, or free-trading shares, had been kept in short positions as of February 1st, up from just 7.5% in April 2021.

Gogo inc. (GOGO)

It serves broadband connectivity to the aviation industry. It’s shares rose to more than 20% in the past six months; however, the stock has come down from its largest gains since the company raised its long-term revenue growth guidance in September. The stock will likely remain volatile and highly exposed to the ongoing pandemic, especially the business travel market.

In January, Gogo announced that it completed a seven-tower 5G testbed and said it plans to add additional sites throughout the first half of 2022, ahead of a planned 5G launch in the second half of the year. Gogo’s short interest is about 39% of its float.

Blink charging co. (BLNK)

Blink Charging owns and operates electric vehicle charging equipment. The stock started to draw attention from short-sellers when it rallied from about $2 in mid-2020 to more than $60 per share in January 2021. Prominent short-seller and Citron Research editor Andrew Left called Blink and said it was a scheme and joke, back in November 2020. He further added that the stock should be trading for less than $10.

Since that time, Blink’s short interest has grown to about 40% of its float, even after the company’s January 2022 announcement of a deal to supply EV chargers to General Motors Co. (GM) dealerships in North America, a move that bolstered the company’s case as a growth play.

Intercept pharmaceuticals inc. (ICPT)

Intercept Pharmaceuticals is a biopharmaceutical company that is developing a potential treatment for chronic liver disease. Intercept has a major potential short squeeze catalyst coming sometime within this quarter of 2022, when it is expected to report phase 3 data on obeticholic acid, or OCA, in treating patients with compensated cirrhosis.

Short sellers are betting a Food and Drug Administration approval for OCA is a long shot. So far, they have made a killing bet against Intercept’s struggling stock, which is down by more than 50% in the past year. Intercept’s short interest stands at about 33% of its float.

Apollo medical holdings inc. (AMEH)

Apollo Medical is a health care management company that specializes in maximizing the efficiency of physicians, health plans, and hospitals. Short sellers recognized an opportunity in Apollo in 2021 after the stock rallied from less than $30 to about $113 per share in about three months. Much of those gains occurred after the S&P SmallCap 600 index added these stocks in June; however, the short-sellers are likely skeptical of the big run.

Ortex estimates that about 42% of the stock’s float is held in short positions, making it an excellent candidate for a short squeeze.

Dillard’s inc. (DDS)

Dillard’s is one of the largest U.S. department stores. Short-sellers likely see brick-and-mortar department stores facing an uphill battle competing against Amazon.com Inc. (AMZN) and other online retailers in the long term. Meanwhile, Dillard’s faces margin pressures from inflation and rising labor costs in the near term. The store reported a big earnings beat in November, however, the analysts anticipate sales and earnings growth will become much more difficult as industry inventory levels normalize.

With expectations low for 2022, another surprise earnings beat could trigger a short squeeze. DDS’s short interest is about 62% of its float, according to Ortex.

Portillo’s inc. (PTLO)

Portillo’s is a Chicago-style hot dog and Italian beef restaurant chain that went public back in October of 2021. While many other top 2021 initial public offering stocks are struggling, Portillo’s stock is still up about 33% from its $20 IPO price as of market close on January 31st. That being said, the stock has dropped more than 20% following the company’s first quarterly earnings report in November. Portillo’s reported an 8.8% year-over-year drop in operating income during the quarter that ended September 26th and was forced to raise prices to offset rising commodity and labor costs.

Short sellers have had some big winners among other recent IPO stocks, and Portillo’s short interest is already at 32% of its float.

Conclusion

Engaging in a short squeeze entails navigating high-risk terrain, with potential pitfalls for those who miscalculate their moves. Short sellers willingly gamble on the chance of amplifying their gains by selling borrowed stocks at diminished prices. These squeezes typically occur at the culmination of profound downturns, such as the early 2020 slump triggered by escalating concerns surrounding the coronavirus pandemic. By this stage, the majority of traders have offloaded their shares. Short squeezes can unfold rapidly, propelling stock prices with unparalleled intensity, potentially resulting in substantial losses for the inattentive.

As prices begin to surge, vigilant new buyers swiftly enter the fray, exacerbating the upward momentum and potentially propelling a stock into a parabolic trajectory. Notably, history is replete with monumental instances of short squeezes, offering invaluable insights for investors keen on deciphering the telltale signs of stocks ripe for squeezing.