What is a Short Squeeze?
Let’s take a closer look at short-selling, a strategy that allows traders to profit from a stock's decline. Short sellers make money by “shorting” stocks they believe are overvalued or poised for a downturn. Here’s how it works:
When you short a stock, you first "borrow" shares from your broker (e.g., through platforms like Robinhood or Schwab) at the current market price. The goal is to repurchase the stock later at a lower price, return it to the broker, and pocket the difference.
For example, let’s say after conducting thorough research, you identify a stock priced at $100 that seems overpriced and likely to drop. You can borrow shares of this stock from your broker and sell them immediately at $100. If the stock price falls to $80, you can buy it back from the market at this reduced price, return the shares to your broker (which happens automatically), and keep the $20 profit (minus any fees).
It’s important to note that short-selling requires a margin account, which introduces additional risks. Unlike buying a stock (where your potential loss is limited to the stock’s price reaching zero), losses from short-selling can be unlimited. This is because, theoretically, there’s no limit to how high a stock’s price can rise, which could mean substantial losses.
Returning to our example, if you short the stock at $100 but it instead rises to $200, you would now face a $100 loss because you’d have to buy it back at the current market price to close your position and return it to the broker. This situation often results in a "short squeeze" — a scenario where a rising stock price forces short sellers to quickly close out their positions to prevent further losses. During a short squeeze, heavy buying pressure from short sellers scrambling to exit their positions drives the stock price even higher.
This is precisely what happened with GameStop and AMC in 2020. These stocks had a high percentage of shares being held short, and as retail investors began aggressively buying, it triggered a short squeeze, which drove prices even higher, causing major losses for those who had bet against them.
Short-selling can be a profitable strategy, but it requires careful research, risk management, and an understanding of market dynamics — especially the potential for a short squeeze.
How Buyers Benefit from Highly Shorted Stocks:
Buyers sometimes look for highly shorted stocks because these stocks have the potential for a short squeeze. When a stock is heavily shorted, meaning a significant portion of its available shares is held in short positions, it indicates that many traders are betting on its decline. If the stock price unexpectedly starts to rise, however, short sellers may be forced to "cover" their positions — that is, buy back the stock to limit their losses. This rush of buying activity from short sellers can push the stock price even higher, creating a feedback loop that drives the stock up rapidly. For buyers, this situation can present an opportunity for quick and substantial gains as the stock surges.
To identify highly shorted stocks, buyers typically look at two main metrics:
1. **Short Interest**: This represents the percentage of a company’s shares that are currently sold short relative to its total shares outstanding. For example, if a stock has a short interest of 20%, it means that 20% of its total shares are being held in short positions. Stocks with a high short interest are often at risk for a short squeeze, especially if there is positive news or renewed investor interest that could push the stock price higher.
2. **Days to Cover (Short Interest Ratio)**: This ratio shows how many days it would take for short sellers to cover all their positions, based on the stock’s average daily trading volume. It’s calculated by dividing the short interest by the average daily trading volume. A high days-to-cover ratio suggests that if the stock begins to rise, short sellers might struggle to exit their positions quickly, creating more upward price pressure.
Buyers often track these metrics through financial platforms and reports that provide short interest data, such as Bloomberg, Yahoo Finance, or specialized brokerage tools. They also keep an eye on social media, online forums, and other channels where sentiment about specific stocks can spread rapidly, potentially spurring a short squeeze.
By monitoring these indicators, buyers can spot potential short-squeeze candidates — stocks that, due to high short interest and favorable market conditions, may experience rapid upward movements that allow them to capture quick gains. However, investing in these stocks also involves significant risk, as the price can be volatile and may drop sharply if the upward pressure subsides.