What is a Short Squeeze? Basics to risks Explained

Soon thereafter, the exchange suspended trading in the stock and gave short-sellers time to return the shares they owned. Eventually, Saunders settled the dispute for $100 per share and took in millions in losses. Naked short selling involves illegally selling short shares that don’t exist.

As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

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However, the notion that hedge funds are somehow responsible for the downfall of such companies is misguided, to say the least. So in anticipation of the current share price continuing to fall, a significant amount of short interest mounts up among investors. A Short Squeeze occurs when securities with a significant short interest rise sharply in value, which further accelerates the upward price movement from short-sellers closing out their positions.

When Porsche announced a takeover of Volkswagen in October 2008, short-sellers scrambled and prices soared. Volkswagen briefly became the most valuable company in the world before prices declined. Short-sellers exit their position by purchasing shares to return to the lender. Derek Horstmeyer is a professor at George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund performance. He currently serves as Director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed investment fund at GMU. To be sure, short squeezes are not especially common phenomena, so even if all four conditions apply, the odds of predicting one are still very long.

Short Squeeze Stocks: GME

That is, naked shorting can force a price drop, which leads to some share sales to cut losses, allowing the market to effectively find balance. It is likely that short squeezes will continue to grab a lot of the attention in the finance world as the market adjusts to the new normal. When that figure is low, the best short squeeze stocks to buy today may not have much long-term potential, as shorts can quickly cover their positions and get out of a stock before it runs up too high. In early 2021, retail investors bought up shares of the video game retailer, sending the share price higher and higher and triggering a short squeeze that nearly bankrupt at least one hedge fund.

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GameStop short squeeze example

Short interest is important because it reveals how investors feel about a particular stock. If a large percentage of a stock’s shares are sold short, there is a chance of a short squeeze occurring if the price rises suddenly. When there’s a large amount of short interest in a stock, a short squeeze can be triggered by something as simple as a positive earnings report or news headline. As more and more short-sellers are forced or decide to cover their positions by buying the stock, the price rises higher and higher. Sometimes a short squeeze convinces other investors to buy, sending the price up even further. A short squeeze is bad news for short sellers and good news for investors going long.

• Short squeezes are usually short-lived and end when short sellers have fully exited their positions or stop buying shares to cut their losses.
• That is, it would take 10 days for short sellers to cover their entire short position based on the average daily volume of shares traded.
• The result of this will not only cause ABC’s share price to increase, but it will also cause other short sellers to get nervous that ABC’s stock is continuously increasing instead of decreasing.
• When there’s a short squeeze, naked short selling essentially creates phantom shares, increasing liquidity in the shorted stock.
• A high short interest ratio can be an indicator of a short squeeze.

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). A positive news story, a product announcement, or an earnings beat that excites the interest of buyers can defeat a short position. In 1901, Edward Henry Harriman faced off with James J. Hill for control over the Northern Pacific Railroad. Both started buying up as many shares as they could get their hands on in an attempt to seize control of it.

One of the biggest short squeezes of all time: Volkswagen

Hedge funds recently pulled back on their short positions as a precautionary measure, which retail investors again interpreted as yet another victory. GME attracted substantial media attention as retail investors celebrated the losses of hedge funds. This was bad news for short-sellers, who had bet the stock would keep falling. Unlike most investors, who want their stocks to appreciate, short-sellers make money when stock prices go down and lose money when they go up. Short squeezes can be extremely volatile, with buying pressure pushing a stock’s price far above its last support level.

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