A short squeeze is an exceptional condition that causes a stock or other marketable security’s price to suddenly rise. A short squeeze occurs when security has an unusually high number of short-sellers holding positions in it. So when the price suddenly rises, the short squeeze ensues. The situation unfolds when a large number of short-sellers choose to cut their losses and abandon their holdings.
Understanding the Concept
When the price of a heavily shorted stock rises suddenly, short-sellers may have to move quickly to minimize their losses. Short sellers acquire stocks of a commodity they predict will decline in value and then purchase them back when the price drops. If they’re correct, they refund the shares and take the price difference between when they started the short and when they purchase them back to conclude the trade. If they’re incorrect, they’ll have to purchase at a higher price and make up the difference between what they fixed and what it sells for.
The coinciding withdrawal of these short sellers drives prices higher because short traders leave their holdings with buy orders. The security’s price continues to grow rapidly, attracting buyers. The mix of new purchasers and terrified short sellers can result in a startling and unexpected price spike.
Short sellers target a commodity that they believe the market has overpriced. With its creative process of creating and marketing electric automobiles, Tesla, for instance, has piqued the interest of many investors. Investors have put a lot of money into it because of its potential. Short sellers bet significantly on the company’s demise. Tesla was the most-shorted stock on the New York Stock Exchange in early 2020, with more than 18% of its outstanding stock in short bets.
Tesla stock gained 400 percent from late 2019 to early 2020. Short sellers took a beating, losing an estimated $8 billion. During a market collapse in early March 2020, Tesla’s stock, like most others, ultimately dropped. During a brief sell-off, short-sellers made around $50 billion.
Why Do Short Squeezes Occur?
Short sellers, as previously said, take positions on equities that they predict will fall in value. A favorable news item, a product introduction, or an earnings beat that ignites the curiosity of purchasers can upend this, no matter how sound their rationale is.
The stock’s fortunes may flip around again, but only for a short time. If it isn’t, the short seller risks incurring massive losses as their holdings near their expiration dates. They usually choose to sell out right away, even if it means taking a significant loss.
This is when the tight squeeze comes into play. Each short seller’s purchase raises the price, forcing another short seller to purchase.
Betting on a Short Squeeze
In an attempt to benefit from the possibility of a short squeeze, contrarian investors may purchase equities with a high level of short interest. While a rapid increase in stock price is appealing, it is not without dangers. For valid reasons, such as a bleak future forecast, the share may be wildly overvalued.
Active investors will keep an eye on companies that are heavily shorted and wait for them to start climbing. When the price starts to gain traction, the trader jumps in to buy, hoping to profit from a possible short squeeze and a large rise higher.
Risks of Trading Short Squeezes
There are several instances of stocks that climbed upward after they had a strong short interest. However, several severely shorted equities continue to decrease in value.
A high level of short interest does not necessarily imply that the price will climb. It indicates that a large number of people expect it will decline. Someone buying in the expectation of a short squeeze should have other (and better) reasons to believe the stock will rise in price.
What is Naked Short Selling?
Short selling a stock without first borrowing the asset from someone else is known as naked short selling. It’s the act of selling shares that haven’t been positively identified as existing. Naked short selling is prohibited by the Securities and Exchange Commission (SEC). The naked shorting strategy entails a high level of risk, but it also entails a high level of gain.
Because of the differences between electronic and paper trading, naked shorting still occurs. Naked shorting can worsen short squeezes by enabling extra shorting that would otherwise be unavailable. On the one hand, naked short selling is said to assist balance the market. That is, naked shorting can cause a price decline, causing some share sales to reduce losses and enabling the market to properly establish equilibrium.