What Exactly Is a Short Squeeze?

If you paid any attention to this year's action in GameStop (GME), you've no doubt heard the words "short squeeze."

If you didn't follow GameStop, you should catch up, purely for the entertainment value. Hollywood is already looking at making a movie about the trading action in the stock's epic run.

GameStop – a struggling retail chain selling video games and accessories – shot higher by as much as 2,464% at the peak of its 2021 short squeeze in January. Even now, after several spurts and pullbacks, it remains up after a considerable pullback, it remains up 1,070%. That's decades' worth of strong returns in less than a year.

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Not bad work if you can get it!

Given that short squeezes can create those kinds of gaudy returns, 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.