Short Squeeze

A short squeeze is a trading phenomenon that occurs when the price of an asset/stock increases unexpectedly, compelling short sellers to buy their securities at a higher price. However, this rapid rise in the buying pressure leads to further increases in the stock or asset prices.

The short squeeze phenomenon is evident when the prices of the assets and securities have constantly been dropping for a significant period. As the stock and asset prices increase suddenly, more and more short sellers try cutting losses by buying back their sold shares.

• A short squeeze situation arises when there is an unexpected increase in stock price, adversely impacting the short-sellers, who are then forced to buy the stocks at a higher price to cover their short position, which results in a further increase in the stock prices.
• The short-sellers are squeezed out of their short positions, usually at a loss.
• The phenomenon increases the buying pressure in the market at one point in time, causing a further increase in security prices.
• Short interest, days to cover, and Relative Strength Index (RSI) are major technical indicators that give traders significant clues about short squeezing.

Short squeeze meaning implies the squeezing out of the short-sellers, given the rapidly and unexpectedly rising prices. Such a phenomenon mostly occurs when considerable short sellers are operating in the market. As such situations arise, more and more short sellers are forced to cover their position.

Multiple technical indicators help identify short squeeze stocks, helping traders prevent losses. Short interest is one of them, indicating the percentage of an outstanding shares of a stock owned by the short-sellers. If the value of short interest is higher than the normal level, there are chances of a short squeeze.

Another indicator on the list is the days to cover. It is calculated by dividing the total short-selling interest in a stock by its daily average trading volume. Theoretically, it indicates how many days short sellers would take to cover their position with respect to their average trading volume. The higher the number of days to cover, the higher the probability of a short squeeze.

Relative Strength Index (RSI), on the other hand, helps assess whether the market is in an overbought or oversold condition. If the RSI is below 30, the market tends to be oversold and undervalued. Hence, there is a scope for a short squeeze.

So far as trading is concerned, traders can buy the stock and sell when the short squeeze seems to end. Otherwise, they can buy a call option on the stock, wait for the stock price to reach a certain high, and then use it to make profits. However, they can also sell the call option to another investor at a higher price and book the profit.

Some factors put the above indicators to work. For example, the major causes that lead traders to buy back their stocks post a short sale include the nature of short sellers, liquidity issues, and stock price rise.

When coming across the constantly rising stock prices after long-term drops in the same, the sensitive short sellers guess the further scenario. As a result, they start buying back the stocks they already sold short. This, in turn, increases the buying pressure in the stock market, which boosts the prices of the assets and securities even more. However, traders' sentiments and news also play a vital role in increasing stock prices. Whatever the reason, the instant and rapid increase in covering the short position creates a huge imbalance in the market liquidity, which also adds to the factors influencing short squeezing.

Although there are many instances where the stock prices move up after a heavy short interest, there is no guarantee that it will always happen. There are instances where the stock price had fallen when they were heavily shorted. So, this risk is always there for investors who intend to profit from a short squeeze situation.

The following charts demonstrate a couple of short squeezes concerning two different stocks — GameStop and Volkswagen on the daily timeframe.

Source

As one can observe, the GameStop chart displays a bigger short squeeze when compared to Volkswagen stock. That said, both are similar from a fundamental standpoint. After all, short squeezes take place in the exact way; only the corrections differ.

With regard to the GameStop short squeeze, one may make the following observations:

• Any individual who caught the trend prior to the run-up made the least risky investment.
• Market participants pushed prices up because of the hype, leading to the formation of the first squeeze.
• The first red or bearish candle suggested that all individuals who made decent gains were accumulating profits, and there was a possibility that market participants closed a few of the short positions.
• The hype persisted, and the ones who were late to the party created another squeeze.
• The second bearish candle represented the people who made decent gains for the second time and closed their positions, people who panicked, and market participants who closed their short positions.

Lastly, one could conclude that the mass hysteria and hype were fading away, and the people who purchased the top, hoping the price would rise further, were trapped.

Individuals can develop a comprehensive idea of this concept by looking at charts like these already published on TradingView.

The short squeeze examples below help us understand the concept more clearly:

Example #1

AMC Theaters recorded a loss worth $4.6 billion post-COVID-19 in 2020. However, the short squeeze phenomenon boosted its share prices to a great extent, giving traders a ray of hope. Recently, there have been speculations of another AMC short squeeze to happen soon despite a reduction in short shares to 89.1 million in August 2022, which is 7 million down from July, with almost 17% of stocks available to short again.

Example #2

Take the example of Volkswagen, where the short squeeze resulted in a significant jump in the stock price in October 2008. As a result, the stock price increased from €210 per share to over €1,000 per share in just two days, making it the most valuable company in the world for a brief period.

The sudden change in investor sentiments happened due to Porsche's announcement that it had expanded its voting shares in Volkswagen to 74%. As a result, the short sellers expecting the stock price to fall were hammered and were forced to purchase the stock at €1,005 per share for short covering.

A short squeeze situation arises when short sellers have to buy back their shares, given the constantly rising market prices. On the contrary, a gamma squeeze involves market makers betting on stocks when they observe multiple call options purchases for a particular stock by traders.

While the terms differ in how they work in the stock market, both contribute equally to significant spiking of the stock prices, causing enhanced buying pressure on the market.

This is a guide to What is Short Squeeze & its meaning. We explain how it works along with its causes, examples, and comparisons with the Gamma squeeze. You can learn more about it from the following articles -

• Long and Short Positions
• Naked Shorting
• Short Covering