What is a Short Squeeze?
The term “short squeeze” has resurfaced as some prominent investors have found themselves “squeezed” out of their short trades. We can all remember the carnage that ensued as notable hedge funds were plagued by a short squeeze during the meme stock rally of January 2021. This occurred when retail traders rallied behind heavily shorted stocks like GameStop and AMC, increasing these securities’ prices in a short period of time. The rapid price increase led to massive losses for those that had shorted the securities, or put another way, bet that the price of the stock would go down. This rally encapsulated what the term, short squeeze, describes and unveiled the liquidity backed power supporting retail investor rebellion.
To provide a further breakdown of a short squeeze, let’s lay out some definitions:
- Shorting a stock or short selling: Describes when a trader borrows shares of a stock and sells the security in the open market, with the belief that the value of the security will decrease. The strategy can be useful if the trader believes the asset is overvalued and believes that short-term selling pressure will present an opportunity to make a profit.
- Going long a stock: Describes when a trader purchases a stock and holds the position, with the belief that the stock is undervalued and presents an opportunity to sell at a higher future price and profit.
- Covering a short: when a trader closes out a short position by buying back the shares previously sold and realizing the profit or loss on the position.
- Short squeeze: A phenomenon that occurs when the price of a heavily shorted security rises rapidly, forcing short sellers of the security to rush and close the position, thus buying back shares on the open market to mitigate heightened losses, and putting further upward pressure on the security.
Going Long and Going Short
Source: Start Online Trading
We describe these terms in greater detail in our article:
To establish a short trade, the short seller needs a margin account to borrow the shares from a counterparty. The counterparty allows the trader to borrow the shares with interest (known as the borrow fee) and establishes risk parameters to limit the losses from borrowing the shares. Unlike when buying shares on margin, when shorting shares, the borrow fee is based not just on prevailing market interest rates, but also the relative supply and demand of available shares to borrow, as determined in what is called the securities lending markets. As more individuals seek to short shares, demand to borrow those shares goes up, and in turn, the cost to continue shorting rises as well. The reverse is true as well – as short interest decreases, the cost to borrow shares in a company also goes down.
Short selling is inherently risky in nature as your potential theoretical losses can be infinite if the stock continues to rise. While being long a stock has its own nuanced risks, the losses are capped at how much the trader has put into the trade. For example, if you purchased a stock at $20/share, the lowest the stock’s price can go is $0. However, with shorting a stock at $20/share, the losses are infinite as the price can go up to any level.
Payoffs of Long and Short Stock Positions
In a short squeeze, when the price of the shorted security goes up instead of down, the short seller must decide whether to continue holding the borrowed shares, hoping the price will fall, or consequently having to purchase the shares at a higher price to exit the trade. This decision can be costly for short sellers because those with high conviction for their short sale could find themselves on the “wrong side of the trade”, no matter how “great” one thinks their investment thesis is.
As we have seen over the years, markets do not always behave rationally. Accordingly, those with a sound investment thesis could find their trade not accounting for the irrationality of the market, technical movements of the markets, and exogenous forces that can undermine their trade.
Source: CenterPoint Securities
A short squeeze usually unfolds after there is a high level of purchases in a short amount of time for a widely shorted security. Going back to our previous definition of long, when a trader purchases a stock, they are doing so because they believe the price will be higher in the future. The same goes for a short squeeze, which is one of the reasons why the market reacts to the large stock purchases by pushing up the stock’s price. When there is a sudden rise in buying pressure, short-sellers scramble to weigh the opportunity cost of holding, or exiting their trades and buying the shares at higher prices. The significant amount of position closing, or short covering applies more buying pressure to the stock and further increases the price of the stock, which extends losses for those that continue to hold onto their shorts. As the price increases, those that are long the stock reap profits, while those short suffer losses. Unfortunately, the short sellers that remain convicted to their short trade idea may end up with insurmountable losses. These losses can be exacerbated by margin calls. When borrowing shares on margin, as losses mount, the lender of shares may enact a margin call to ensure there is sufficient money in a trader’s account to recoup those shares. As the famous Keynes adage goes: “Markets can stay irrational longer than you can stay solvent.”
There are certain technical indicators that typically happen before a short squeeze occurs, such as:
- Sudden rise in long purchase volume: This is illustrated by a sudden, rapid increase in the number of shares purchased. The purchases can indicate to the market that there has been a sentiment change, and that there is a large number of investors that believe the future price will increase, leading the price to rise.
- Short Interest of 20% or higher: Short interest is defined as the “percentage of the total number of outstanding shares held by short-sellers”. A high short interest indicates a high amount of the shares outstanding are being shorted. A higher percentage usually presents the opportunity for a short squeeze to develop.
- Short Interest Ratio (SIR) above 10: The SIR compares the short interest to the average daily trading volume. The ratio illustrates, in the context of the average trading volume, the theoretical days needed for the short sellers to exit their trades. An increasing SIR ratio indicates it is likely a short squeeze is coming.
- Relative Strength Index (RSI) below 30: Measured on a scale of 0 to 100, the RSI indicates whether the market is overbought or oversold. A low RSI (<30) means the stock is oversold, trading at a very low price relative to its historical average trading price, and may be due to rise. A stock with a high RSI means the stock is severely overbought, trading at a very high price relative to its historical average trading price, and may be poised to fall.
After suffering a short squeeze, many short-sellers lick their wounds and rethink their short-selling trade ideas in the future. The reasoning for the short sell trade idea could still be valid for the future, but not designed for the current environment. A stock could turn around from a variety of reasonings, surprise earnings report results, company announcements, or the collective power of investors rallying behind the stock.
With shorting, given the losses are uncapped and can be insurmountable, the potential for the trade going wrong is high. The complexity of these strategies is typically for professional traders who have the experience and expertise. However, even professional traders and institutional players have suffered losses from shorting as there simply is no guarantee that any short selling strategy will pay off.
Nevertheless, some hedge fund managers employ short-selling strategies to illustrate their conviction behind an investment thesis towards a stock. While these managers are not immune to falling prey to a short squeeze, certain managers have the investment acumen to unwind a trade when needed. Finding the right manager to navigate in these waters is tricky and underlines the importance of conducting a thorough investment due diligence. The investment due diligence process can help highlight some of the factors behind a manager’s investment conviction, such as track record, drawdown patterns, volatility, and history the team has spent investing together, to name a few. However, short-selling strategies are inherently risky, and investing in managers that adopt these strategies should be assessed as such.
A short squeeze is a difficult environment to handle, and even the most sophisticated investors can be caught up in one. While a short squeeze cannot be avoided, it is important that investors understand the risks associated with the short-selling and have the humility to unwind a short trade when necessary. A short squeeze can occur in a relatively short period of time, illustrating the need to act timely in a high-pressure situation. Those short-sellers that remain in their trade during a short squeeze will need an iron stomach to face the buying pressure from not only those that originally initiated the buying pressure but also the other short-sellers that are exiting their trades and purchasing the stock. It goes without saying, short selling is incredibly risky, and short squeezes further add to the risks associated with the strategy.