investing

What Exactly Is a Short Squeeze?

A short squeeze is a quick path to getting a lot of juice out of a stock. We explain the phenomenon, and the short selling that fuels it.

If you've been watching the action in GameStop (GME) lately, you've no doubt heard the words "short squeeze."

And if you haven't been following GameStop, you should, purely for the entertainment value. They might very well make a movie about the trading action in that stock over the past few weeks. As I'm writing this, GameStop – a struggling retail chain selling video games and accessories – is up roughly 2,300% in 2021 alone. That's decades' worth of strong returns in less than a month.

Not bad work if you can get it!

If a short squeeze can cause a move like that, it's worth reviewing what exactly a short squeeze is. And to do that, we need to review what short selling is.

The Basics of Short Selling

Short selling – or shorting – is placing a bet that a stock declines in value. To do this, you borrow shares from another investor and then sell them. (Your broker does this for you behind the scenes.)

But remember: Those shares aren't yours to sell. You borrowed them. This means you are obligated to buy the shares back so you can to return them to the original owner.

There is an old saying attributed to Daniel Drew, a legendary speculator of the late 1800s:

"He who sells what isn't his'n, must buy it back or go to pris'n."

They don't send bankrupt short sellers to prison anymore, but the obligation to buy the shares back is very real. And this is where short squeezes come into play.

What Is a Short Squeeze?

Let's say that a short trade has gotten crowded. You have a lot of short sellers, all of whom have borrowed shares and all of whom must eventually pay them back. This is a tinderbox just waiting for a match.

If something – anything – causes the stock to rise, it can quickly turn into a buying frenzy as the short sellers trip over one another to buy the shares so they can cut their losses and exit the trade. The higher the stock price goes, the more short sellers are forced to cut their losses by buying back the shares they sold. And their frantic buying drives the price even higher, forcing more short sellers to follow their lead.

Panic-buying begets more panic-buying, egged on by speculators who know the situation the short sellers are in and actively try to put the screws to them. This is a short squeeze in action.

And it's exactly what happened in the shares of GameStop.

How to Avoid a Short Squeeze

Short selling is risky because it has limited upside, but unlimited downside.

If you short a stock at $10, it can't go lower than zero, so you can't make more than $10 per share on the trade. But there's no ceiling on the stock. You can sell it at $10 and then be forced to buy it back at $20 … or $200 … or $2 million. There is no theoretical limit on how high a stock can go.

The first way to avoid getting squeezed is simply to avoid shorting. But if you do decide to short, make sure you keep your position sizes modest and try to cut your losses early if the trade goes the wrong way.

Perhaps most importantly, watch out for highly shorted stocks. Short squeezes only happen when a lot of traders have shorted the same stock. So, avoid stocks with high short interest.

When it comes to short selling and short squeezes, there are a couple of important data points to monitor.

There's the "short percentage of the float" – that's the percent of the shares available for trading that are currently being held short. Anything above 10% is at least noteworthy. At one point, more than 100% of GameStop's float was sold short – an excessively high number meaning that every share available was borrowed at least once to be sold short, but some were borrowed multiple times.

The other useful metric here is the "short ratio," or "days to cover," which is the number of days of normal trading it would take to generate enough trading volume to buy back all the shares sold short. There is no hard and fast rule here, and opinions vary widely, but a decent rule of thumb is 10 days. Ten days or longer to cover might indicate a crowded trade, and one you might want to avoid lest you get squeezed.

Most Popular

The Perfect Storm for Retirees
retirement planning

The Perfect Storm for Retirees

Today’s retirees could face a perfect storm because they are living longer and spending more time in retirement, while at the same time losing access …
April 18, 2021
Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs
Coronavirus and Your Money

Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs

People have lots of questions about the new $3,000 or $3,600 child tax credit and the advance payments that the IRS will send to most families in 2021…
April 14, 2021
Where's My Stimulus Check? Use the IRS's "Get My Payment" Tool to Get an Answer
Coronavirus and Your Money

Where's My Stimulus Check? Use the IRS's "Get My Payment" Tool to Get an Answer

The IRS has an online tool that lets you track the status of your third stimulus check.
April 4, 2021

Recommended

15 Best ESG Funds for Responsible Investors
investing

15 Best ESG Funds for Responsible Investors

ESG, SRI ... call it what you want, but it can take many forms, and stand for different values. These 15 funds give you options.
April 20, 2021
Will 2021 Be the Year for Value Stocks?
investing

Will 2021 Be the Year for Value Stocks?

It’s true that growth stocks have been hotter for years, but value stocks might be ready for their day in the sun. A series of factors, including a po…
April 16, 2021
How to Invest Green in a White-Hot Market, with Anne Kates Smith
Kiplinger's Investing Outlook

How to Invest Green in a White-Hot Market, with Anne Kates Smith

Sustainable stocks are going gangbusters. In an era of triple-digit gains for many market favorites (it's not just Tesla), we look for value options. …
April 15, 2021
Gen I: What Investing's New Class Looks Like
investing

Gen I: What Investing's New Class Looks Like

COVID-19 has been a disruptive force in the global economy. But it also has created opportunity for a new group of investors dubbed "Gen I."
April 9, 2021