Short Squeeze Explained for Beginners

Short Selling and Short Squeeze Basics

0:00 To understand a short squeeze, you must first understand short selling. Most investors make money by buying a stock and hoping that that stock rises in price. Short sellers do the exact opposite. A short seller is actually betting that the price of the stock is going to go down. To place a short trade, the investor must actually borrow shares from their brokerage firm and immediately sell them on the open market. The short seller then hopes to actually watch that share price go down, buy the shares back at a lower price, and keep the difference as a profit.

0:34 For example, imagine that an investor shorts 100 shares of a given stock at $50 a share. The investor sells the borrowed shares. A few weeks later, that stock falls to $30 per share. The investor can now purchase those same shares for $3,000, return them to the brokerage firm that they initially borrowed from, and keep that profit of $2,000. This is the ideal outcome for a short seller. But, what happens when the stock moves in the opposite direction?

1:03 Instead of the stock falling from $50 to $30, imagine the stock rises from $50 to $80. The short seller still needs to buy those 100 shares back to successfully close their position. But, those same shares will now cost them $8,000. This generates a loss of approximately $3,000. The key thing to understand about short selling, unlike when you buy a stock, the most you can lose is 100%, the short seller actually subjects himself to an unlimited loss.

1:36 A stock can only fall to zero, but in theory, there's actually no limit to how high a stock can rise in price. This unlimited loss potential is what creates the conditions for a short squeeze.

How a Short Squeeze Starts

1:46 A short squeeze happens when a heavily shorted stock begins rising and short sellers rush to close their positions. To close their short position, the short seller must actually buy back the shares they sold short. That buying creates additional demand for the stock, which pushes the price higher. As the price continues rising, more short sellers lose money. Some voluntarily close their positions because they are worried about having even larger losses.

2:12 Others may be forced to actually close their positions because they are not meeting the collateral requirements of their broker. Every short seller who closes their position becomes another buyer of that stock. This can create a feedback loop. Price starts rising, short sellers begin covering their positions. Their buying pushes the price even higher. That higher price forces even more short sellers to buy back the shares and cover their positions.

2:37 And that cycle continues until the buying pressure finally runs out. That feedback loop is called a short squeeze.

Short Squeeze Example

2:44 Here's a simple example. Imagine that a company has 10 million shares available for trading. Investors have sold 3 million of those shares short. That means approximately 30% of the company's share float has been shorted. Now, imagine that that company unexpectedly releases some positive news. Maybe the shorted company announces better than expected earnings, announces a new partnership, or receives regulatory approval for a product that would be significant to the company's bottom line.

3:11 Regular investors begin buying the company based on that good news. The stock price rises 10%. Some short sellers decide to close their positions before their losses become larger, which creates additional buying pressure. That pushes the price up another 10%. Other traders notice the momentum and begin buying the stock as well. The stock continues to rise, which creates even more pressure for the short sellers. At this point, the stock is rising for two major reasons.

3:38 The first reason is the positive news that attracted the initial buyers. The second reason is the forced or defensive buying from the short sellers. When both sources of demand happen at the same time, the bullish upside can be surprisingly violent and fast. One of the first statistics that investors look into when evaluating the potential for a short squeeze is short interest.

Short Interest and Public Float

3:58 Short interest measures the number of shares that have been sold short that have not been repurchased. It is often expressed as a percentage of the stock's public float. The public float is the number of shares that public investors are allowed to trade. For example, imagine that a company has a public float of 20 million shares and 4 million of those shares have been sold short. The short interest as a percentage of the float would be 20%. A higher short interest percentage means that a higher proportion of that company's share float has been shorted.

4:31 There is no universal percentage that makes a stock right for a short squeeze. However, investors might start paying closer attention when the short interest rises to 10 or 15% of the float. Short interest above 20% would be considered unusually high for most stocks. But context is extremely important. A company might have high short interest because sophisticated investors believe that the company has some serious financial problems. High short interest is not automatically a bullish signal.

5:02 It simply means that a lot of investors are betting against a company. The next important metric to cover is days to cover ratio, also known as the short interest ratio.

Days to Cover Ratio

5:11 Days to cover estimates how many days it would take for short sellers to rebuy all the shares they sold short based on that stock's average daily trading volume. The formula is relatively simple. Divide the number of shares sold short by the average daily trading volume for that stock. Imagine that 5 million shares of a stock have been sold short and the average daily trading volume is 1 million. In this case, the days to cover ratio would be five.

5:37 In theory, it would take approximately five trading days for every short seller to close out their position. A higher days to cover ratio can actually make a short squeeze more powerful because it suggests that there is not enough average trading volume for short sellers to exit their positions quickly. If a large number of people are all trying to buy shares at once, remember there's not only the short sellers covering, but there's also the people that are just chasing the momentum and buying the stock.

6:11 Then this can make it to where the price will have to rise significantly to attract enough sellers to accommodate all of that demand. However, days to cover is not perfect. Trading volume can increase dramatically during major news events. So the actual time that it would take for short sellers to be able to exit their positions might actually be a lot shorter based on this higher than average volume. Like we discussed earlier, high short interest alone is not enough to generate a short squeeze.

6:38 The stock typically needs a catalyst that causes lots of buyers to enter the market.

Catalysts That Can Trigger a Squeeze

6:42 Catalysts can include strong earnings, an improved financial outlook, regulatory approval, a new product, a new contract, just any unexpected significantly bullish news event. Even a rumor can sometimes be the catalyst for a short squeeze, although relying on rumors is definitely a lot more risky than an actual news event. The most important point is something needs to change significantly to disrupt the short sellers thesis. If investors are shorting a company because of declining revenues, surprisingly strong revenues could make them reconsider.

7:15 If investors are expecting [clears throat] a company to run out of cash, an unexpected successful financing deal could reduce that immediate bankruptcy risk. The stronger and more credible the catalyst, the more likely it is that short sellers will begin questioning their thesis and closing their positions. The available supply of shares also matters.

Low-Float Stocks and Share Supply

7:35 If demand suddenly increases while the supply of shares remains limited, then it is very likely that that price is going to move to the upside quickly. This is one reason why low share float stocks often appear in the conversations for potential short squeezes. However, low float stocks also come with their own risks. Low float stocks can be extremely volatile, have wide bid and ask prices, and decline sharply with little warning. It is important to remember that a limited share supply can accelerate the move in both directions.

8:08 A potential short squeeze becomes a lot more interesting when the price and trading volume begin moving in the same direction.

Price, Volume, and Momentum

8:13 A price increase on unusually high volume can indicate that meaningful demand is coming into the stock. This demand could come from regular investors, momentum traders, institutional investors, or of course, short sellers closing their positions. Investors may also watch where the stock rises above an important level. For example, a stock that moves above a previous all-time high or a widely followed moving average might attract a lot of technical traders.

8:45 However, price and volume alone should not be viewed as proof that a short squeeze is happening. The buying could disappear just as quickly as it appeared. By the time the move becomes obvious, it's possible that much of the squeeze has already happened. You may also hear people use the terms short squeeze and gamma squeeze as if they mean the same thing.

Short Squeeze vs. Gamma Squeeze

9:02 They are related, but they are not identical. A short squeeze is primarily driven by short sellers buying those shares back to close out their positions. A gamma squeeze is actually connected to options trading. When investors purchase a large number of call options, the institutional firms that are selling these call options may also buy a lot of shares of the underlying stock to hedge their risk. As the stock price rises, those firms might actually need to buy more shares of that underlying stock.

9:33 That hedging activity can increase the upward buying pressure. A short squeeze and a gamma squeeze can actually happen at the same time. When they do, the combination of a gamma squeeze and a short squeeze can create an especially dramatic move.

The Biggest Short Squeeze Risks

9:45 Now, make no mistake, short squeezes can produce dramatic gains in a short period of time, but they are also extremely high risk. The first problem is timing. Even if a trader or investor identifies a heavily shorted stock, there is no way to know exactly the timing of when that short squeeze will actually begin. The second problem is that high short interest might actually be justified. Short sellers might be betting against a particular company because the revenue is declining.

10:12 Maybe the debt is unsustainable. Maybe the management has lost credibility or the business model itself is just failing. A temporary short squeeze does not fix those underlying problems. The third problem with short squeezes is that short squeezes can reverse very quickly. Once short sellers finish covering and the speculative buyers or traders stop buying the stock, the demand can collapse. A stock that undergoes a short squeeze and rises 100% in just days can just as quickly lose 50% of its value.

10:44 Space The final buyers entering the short squeeze are often times the ones that end up with the largest losses. Another crucially important risk is dilution. I've seen it time and time again, companies with a weak balance sheet that undergo a short squeeze take advantage of that rising price and sell more shares on the open market. A public offering will increase the number of shares available to trade on the open market and will ultimately reduce the amount of pressure behind a short squeeze.

Short Squeeze Checklist

11:21 Short sellers purchase shares to limit their losses. That additional buying pushes the share price higher and causes more short sellers to exit their positions. Under the right conditions, this circumstance can create an explosive upward move. But high short interest does not guarantee a short squeeze will happen. And even when a short squeeze does happen, buying near the top can create some devastating losses. Although not as devastating as the short sellers potential losses.

11:49 Understanding short interest, days to cover, catalyst, trading volume, and the publicly available trading float can help you analyze a short squeeze type of situation more intelligently. But none of these indicators should be used in isolation. The goal should not be to chase every stock that appears on a short squeeze list. The goal should be to understand what factors are causing the price action, measure and consider what is your risk, and make decisions based on evidence instead of hype.

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