What is a short squeeze?

A short squeeze could spell disaster for short sellers unless they act quickly. Discover everything you need to know about a short squeeze, including what causes it and how to identify when one might happen.

What is a market squeeze?

A market squeeze can refer to either a ‘short squeeze’ or a ‘long squeeze’. A short squeeze affects short sellers, who are effectively ‘squeezed’ out of the market in light of rapidly increasing prices. They will attempt to exit their short positions as quickly as possible to cut their losses.

A long squeeze is when buyers – people who are long on a stock – are ‘squeezed’ out of the market in light of suddenly decreasing prices. Again, they will attempt to exit their positions quickly to prevent heavy losses.

What is a short squeeze?

A short squeeze is when market prices rise rapidly beyond what analysts and market participants had expected. Short squeezes can hit investors who are shorting the market with borrowed stocks particularly hard, because they could end up spending more money to rebuy and return the borrowed stock – known as short covering – than they anticipated.

They can also be damaging for traders who are shorting a stock with financial derivatives like CFDs. This is because derivatives are traded with leverage which can increase both your profits and losses. This is especially true during a short squeeze or similar scenario where markets behave in an unexpected way.

What causes a short squeeze?

A short squeeze is caused by a rapid and unexpected surge in the price of an asset – usually a stock. Short sellers will seek to abandon their short positions as prices rise.

This causes demand for the stocks to rise, which reduces supply. This shift in the supply-demand dynamic causes prices to rise further, which compounds the effect of the short squeeze.

If investors are using a short covering strategy with borrowed stock, they will need to buy back the shares which they have borrowed to open the short position before the expiration date arrives. The expiration date in a short cover is the date on which the borrower agrees to return the stock to the lender.

How to identify a short squeeze

To identify a short squeeze, many traders will use chart indicators to find oversold stocks. If a stock or other asset is oversold, then people might expect its price to increase. Popular indicators that are used to identify oversold areas include the relative strength index (RSI) and the Williams %R.

In the below screengrab – taken from our trading platform – the RSI is the top indicator and the Williams %R is the bottom indicator. Oversold areas are shown by the rectangular highlights.

You can pair these indicators with the stock’s short interest – the total number of shares that have been sold short, but which have not yet been covered or closed, expressed as a percentage. This can help you to confirm the indicators’ findings, with a lower short interest denoting that fewer traders are currently shorting the company’s stock – meaning that they could be expecting the share price to rise.

To see the short interest, divide the number of shares that have been sold short by the total number of shares outstanding, then multiply the outcome by 100.

Short squeezes will usually catch the markets off guard, and oversold indicators and a high or low short interest do not guarantee that a short squeeze will happen. Often, higher than expected company earnings, technological breakthroughs or new sector-shifting products will cause prices to rise unexpectedly.

Short squeeze example

A notable short squeeze happened in October 2008, when the Volkswagen (VOWG) share price quintupled from €210 to over €1000 in two days. It caught the market completely by surprise and, for a brief period, Volkswagen was the most valuable company in the world.

The squeeze was caused by a perfect storm. Porsche announced that it had gained control of 74% of Volkswagen’s voting shares, which caused its share price to rise sharply, with short sellers forced to pay as much as €1005 a share to close out their positions.

A more recent short squeeze example would be Tesla’s (TSLA) share price in the early months of 2020. Previously, Tesla had been the most shorted stock on the Nasdaq exchange, but a slew of positive news – including fourth quarter results that topped expectations – caused the price to rally to over $900 a share.

Learn more about buying, selling and shorting Tesla shares

Short sellers were caught out and, as with Volkswagen, a scramble of buying ensued to cover short positions and close out losses. This pushed prices higher still, which meant that losses for short sellers were increased exponentially.

Below, you can see Tesla’s share price from 23 January 2020 to 18 May 2020. The short squeeze is circled and labelled as the share price reverses from its downward trajectory, and the increasing share price is shown by the upward arrow in the face of increasing demand.

How to trade a short squeeze

  1. Create or log in to your trading account
  2. Research the market you want to trade
  3. Carry out your own analysis
  4. Take steps to manage your risk
  5. Open, monitor and close your position

To trade a short squeeze, you’d need to open a position that stands to profit from rising share prices. This means you’d open a position to buy (go long) with spread bets or CFDs once you’ve identified a short squeeze.

Spread bets and CFDs are traded on leverage, which means you won’t take ownership of the shares and you can open a position with a small deposit – called margin.

If you’d rather invest directly, you can do so with a share dealing account. You’ll take ownership of the shares, becoming a shareholder in the company with voting rights and eligibility to receive dividend payments – if the company pays them.

An investment position will be profitable if the shares increase in value, meaning that it will often perform well during a short squeeze and rapidly increasing prices.

Short squeeze summed up

  • Short squeezes are bad news for investors who are short selling with borrowed shares
  • They happen when prices increase quickly and unexpectedly
  • This can catch short sellers out – forcing them to buy back the borrowed shares at a high premium to close their positions
  • As a result, demand for the shares rises and supply falls, which pushes prices higher
  • Losses for short sellers could be exponential during a short squeeze, and gains for those with long positions could be dramatic

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Publication date : 2020-07-01T17:37:26+0100

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