What is a short squeeze?

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February 05 2021
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Volatile stock price movements, such as that of US video-game retailer GameStop and entertainment company AMC, have captured the attention of both market spectators and international audiences. The surge in prices in the basket of stocks is brought about by a short squeeze and its options-related cousin, the gamma squeeze.

What does a short squeeze mean? Let’s look further into this sharemarket phenomenon, and the short selling that fuels it.

A short squeeze occurs when a stock that is heavily shorted receives positive news or a new catalyst that brings in a lot of new buyers to the stock. Short sellers (who have betted against the stock) rush to hedge their positions in the event of an adverse price movement to cover their losses.

This causes a sharp increase in demand for the stock, or a short squeeze, and consequently drives up share prices.

How does a short squeeze happen?

Before we understand how a short squeeze occurs, we must be familiar with the trading concept of short selling.

Shorting or short selling is when an investor places a bet that the price of stock will decline. They do this by borrowing shares of the asset that they believe will drop in price (usually from a broker or from another investor) and sell them.

If they are right, they buy the sold shares back later at a lower price point. The borrowed shares are then returned to the lender, plus interest. Investors make a profit by pocketing the difference between the sell price and buy price.

But what happens when they’re wrong? After all, speculation is an important factor when trading shares. An unexpected piece of favorable news (such as a positive forecast, a product announcement, or an earnings beat that excites the interest of buyers) can easily cause a rise in the stock’s share price.

In some instances, the rally in the stock may prove to be a temporary fluke. But if it’s not, short sellers have to act fast as short sales have an expiration date. So, when a stock unexpectedly rises in price, they have to move to cover their losses.

That’s where the short squeeze comes in. In the event that a shorted stock rises in price, short-sellers are forced to buy at a higher price point and pay the difference between the price set and its sale price to cover their losses.

This buying can turn into a feedback loop. Demand for the shares builds up buying pressure, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions. A short squeeze happens when there is a lack of supply and an excess of demand for the stock due to short-sellers covering their positions by purchasing large volumes of stock relative to the market volume.

What stocks are prone to a short squeeze?

Stocks with a low volume of traded shares, with small market capitalisation and small floats are more likely to experience short squeezes. But market squeezes can also involve large stocks with massive market capitalisations.

Short squeezes are also more likely to happen when a significant percentage of a stock’s float is short and a large portion of the stock is held by long-term investors.

A short squeeze can occur when the demand from short-sellers exceeds the supply of shares to borrow, which leads to the failure of borrow requests from prime brokers. This scenario often happens with firms that are on the brink of filing bankruptcy.

Expensive borrow rates on stocks can also facilitate a short squeeze. The high borrow rates can heighten the pressure on short sellers to cover their position.

How does a short squeeze end?

Short squeezes typically don’t last long. This is because the rise in the stock price tends to be because of short-term technical factors than long-term fundamentals of the company. As seen in the GameStop short squeeze, the increase in prices are usually powered by human behaviour and technical factors.

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

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

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