Upbeat music plays throughout.
Narrator:
Not every investor expects that a stock's price will keep rising. Some people short stocks, or expect the price to decline. Of course, there are unique risks when shorting, including the possibility of getting squeezed.
That squeeze, known as a short squeeze, can be a very scary moment for a trader—like wanting to get off a roller coaster as it's going up. It can happen when a lot of traders have shorted a stock, and then its price increases dramatically. When it does, short sellers typically try to limit their losses by exiting their short position.
But to exit, they have to buy shares, causing the price to shoot up even more. Some investors might think they're better off just waiting out the roller coaster ride, no matter how scary it is. When a short squeeze happens, short traders are facing a possible loss so dramatic it's a reminder of the theoretical maximum loss of a short sale: unlimited.
Let's back up for a second and discuss shorting. What is it exactly? You've probably heard the old investing advice to buy low and sell high.
When an investor is shorting, it's the opposite: Sell high, then buy low later. They're trying to profit from stocks that decline in value. Here's how a favorable short could work:
Let's say an investor has picked a stock they think might fall. They borrow shares of the stock through their broker, which they then sell on the open market. They then buy the same stock back, hopefully at a lower price, and return the shares to their broker. After that, any profit is theirs, minus the cost of any transaction fees.
But what if the stock goes up?
To repay the borrowed stock, they'd have to pay a higher price rather than a lower one. The loss would only increase if they wait and the share price continues to rise. Those with a short position can find themselves either holding on for dear life or forced to jump ship before potential losses pile up too high.
A short squeeze can occur when lots of investors find themselves in this position, which can exacerbate the problem and send the price even higher.
Anything can flip the direction of a stock and possibly cause a short squeeze.
Something relatively common, like an unexpectedly solid earnings report, could cause a spike in the price and trigger a short squeeze scenario.
Other situations that lead to a short squeeze can be less obvious. Activist investors can sometimes cause commotion that stirs investor interest, like acquiring a large stake in a company, which can cause sudden movements.
For example, when billionaire Bill Ackman shorted Herbalife, he was vocally negative about the company. Meanwhile, another activist investor, Carl Icahn, took the opposite side of Ackman's short and praised the business. Herbalife's share price jumped 51% in 2017, resulting in an estimated billion-dollar loss for Ackman.
Though short squeezes don't always come about from such public causes. It can be tricky to know that a short squeeze is happening until it's already happened. So it's important to consider a few things when shorting a stock.
There's almost always uncertainty surrounding earnings reports. Some traders think this may be a smart time to avoid short selling. Placing limit orders for entries can potentially help too, which attempt to prevent the trade from filling at a different price than expected. Though there's no guarantee your order will fill.
Also, short sales can only be done in a margin account. When trading on margin, be aware of your maintenance margin requirement. However, that alone may not be enough protection from a short squeeze. Large losses from a short squeeze can cause margin calls that may force investors with a short to buy the stock back to close the trade, locking in those large losses.
On the flip side, some long investors might be tempted to jump on the roller coaster—purchasing a stock after seeing it rapidly rising hoping to profit from a potential short squeeze. For anyone who considers it, it's important to keep your eyes and ears open to the news. Be careful: Short squeeze phenomenon don't always go the way you hope. Traders tend to be mindful of getting out of the trade, and often plan the exit in advance, even as soon as when they enter the trade. Those who hang on too long may end up unable to sell at an appealing price—before the stock price falls, turning potential gains into a losing trade.
Look at this chart for XYZ's share price. Many buyers were excited when the stock, which has traded at less than $10 per share for years, rose past $80 per share. But by the end of the month, it was back down below $16 per share. People who sat on their hands lost out on the impressive gains they saw, while others who sold took a profit. Remember, traders generally plan for both entrance and exit from a position. That can be even more critical for a stock that's going through the volatility of a short squeeze.
Because it's so tough to identify a short squeeze until it's already happening, many short sellers are convinced it's important to have exit strategies for positions. Traders can place stop orders that would hopefully protect from extreme losses, whether trading long or short.
Keep in mind stop orders have their own risks; we never know with certainty where a stop will fill. While our hope is to see a fill close to our stop price, the market can gap up or down between trading sessions and turbulent markets can happen at any time. Traders can also consider using limit orders to either take profits or curb losses. While a limit order will only fill at the set price or better, there is no way to know if the limit order will fill at all.
Remember, when it comes to trading, nothing is guaranteed. Whether you're on the bearish or bullish side of a short squeeze, there's always risk.
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