What's a Short Squeeze and Why Does It Happen?

The aim of short selling is to generate profit from a stock that declines in value. (Short selling involves borrowing a security whose price you think is going to fall from your brokerage and selling it on the open market. Your plan is to then buy the same stock back later—hopefully for a lower price than you initially sold it for—and pocket the difference after repurchasing and returning the loaned shares.) While there are potential benefits to going short, there are also plenty of risks. One big risk is when a bullish catalyst (e.g., earnings, news, technical event, etc.) pushes the stock price higher, prompting short sellers to "head for the exits" all at once. As the shorts scramble to buy back and cover their losses, upward momentum can build on itself, causing the stock to move sharply higher. This is known as a short squeeze.

What makes a short squeeze so dangerous? Think of it this way: When you buy a stock, the worst thing it can do is drop to zero. But the upside for a stock, in theory, is unlimited. If a stock has a growth narrative and there are enough believers, the share price can go well beyond what looks reasonable by traditional fundamental metrics.

Classic ingredients for a short squeeze can include:

• A security has a significant number of short sellers (short interest) who believe the stock price is going to fall
• A dynamic narrative that tries to justify the detachment of share prices from a company's intrinsic value
• A case for massive growth as well as for financial stress
• Traders with deep pockets aligned on both sides of the trade, often using options and other leveraged instruments

With GameStop (GME) in 2021 and Tesla (TSLA) in 2020, there were many classic signs of a short squeeze. Traders with short positions were covering because they had to, either because they had sustained large losses or shares were no longer available to be borrowed. In 2022, short sellers targeted troubled companies such as Bed, Bath & Beyond (BBBY) and Carvana (CVNA). In early 2023, the most heavily shorted companies included Coinbase Global (COIN), a cryptocurrency firm, and Occidental Petroleum (OXY).

When a stock suddenly experiences a dramatic climb, with or without good news, it's important to ask yourself, "Who would buy shares up here?" The answer is possibly someone who doesn't have enough money to hold on to a struggling short position any longer, or someone whose pain threshold has finally been crossed and is buying to stave off even greater losses.

If you're a long-term investor who happens to own a stock that's getting squeezed, it's probably not a good time to add to that position. Instead of acting on emotions, remember why you bought the stock in the first place and consider where you'd like to be. If a stock that's in squeeze territory doesn't fall within your long-term objectives, you might want to step aside and not get involved, if you don't already hold a position. If you do decide to venture in, make sure you have no illusions or misconceptions of the dangers. Understand that when you're dealing with a stock that's being squeezed, you're taking a big risk.

That said, identifying a short squeeze can be relatively simple—after the fact. The trick is to identify the conditions that could lead to a squeeze ahead of time and then determine how you might want to play it (or not).

Shorting a stock is a complicated business. Because you can't sell something you don't own, shorting requires the seller to "borrow" the stock (and pay interest to the stock lender) and then sell it. Locating the shares can sometimes be difficult for your clearing firm because of high demand or a small number of outstanding shares.

Measuring a potential short squeeze can involve a metric called the short interest ratio, a.k.a. "days to cover." It indicates, in days, how long it would take to cover or buy back all the shorted shares. Basically, you divide the number of shares sold short by the average daily trading volume. The more days to cover, the more pronounced the squeeze effect can be.

Another measure is "short interest as a percentage of float," which reflects the number of short-sold shares in proportion to the total number of shares available for trading in the public markets. Most stocks have a small amount of short interest, usually in the single digits. The higher that percentage, the greater the bearish sentiment may be around that stock. If the short percentage of the float reaches 10% or higher, that could be a warning sign.

If you're evaluating a stock that seems to be in the throes of a short squeeze, especially at high levels, it helps to understand other potential reasons why the stock might be moving.

Consider checking the fundamentals. Is there anything that would make you want to own the stock? Are you tempted to buy it only because everyone else is? It's important to always do your homework and remember it's never wise to go all in. A stock that's in a short squeeze may still have a long way to climb, but if you don't think the fundamentals support higher prices, then perhaps you should look elsewhere.

In the case of TSLA in 2020, there were some positive fundamentals underlying the short squeeze, including the company's more consistent profitability and hopes of it being included in the S&P 500 Index (SPX). The stock saw its share price run up to new highs, then decline nearly 60%.

But then TSLA rallied again and split its shares, and its addition to the SPX became a reality, illustrating that a short squeeze doesn't always have to end badly. Other stocks that were caught up in short squeezes haven't always fared so well, in part because they didn't have the fundamental support.

If you want to play the upside of a stock that is experiencing a short squeeze—that is, buying a stock with a higher short interest in order to potentially benefit from a further rise in the price—here are some things to consider:

1. Trading such a stock may be okay as long as you understand the risks and how to control them. Whether you make small or large trades, you have to control and limit the risk. Decide how much money you would be comfortable losing in any trade ahead of time.
2. If the stock still has very weak fundamentals, yet is moving significantly higher without any real, structural changes in the corporation, then be extremely careful buying on this type of upward momentum. The markets may run out of new buyers willing to pay higher and higher prices and the stock may in the end fall quickly.

A short squeeze is a high-risk situation, and it may cause havoc in the market, but it won't last forever. If you decide to trade around it, make sure you have a plan in case things go against you.