What is a short squeeze?

If you’ve been investing for a while, you probably remember Volkswagen’s short squeeze, and if you’re newer to the game, GameStop’s may come to mind. Simply put, a short squeeze occurs when many investors go short on a stock (bet against it), but the stock’s price instead shoots up. As a result, many investors will quickly exit their short position by buying back the shares to limit losses or safeguard any profits if the stock price continues to rise. In other words, they are ‘squeezed’ out of their positions.

What happens during a short squeeze?

For background, when investors go short, they are speculating that the price of a stock will decrease. So, they sell shares they do not own with the goal to buy them back at a lower price. If successful, the profit is the difference between the sell and purchase price. If the stock price increases and becomes greater than the price that the sell price, the investor will suffer a loss. A stock’s price can keep rising, meaning there’s theoretically no limit to the amount of money an investor can lose when they go short. To limit potential losses, many short-sellers use a stop-loss order. Positions are then automatically closed when the price hits a certain level.

During a short squeeze, a heavily shorted stock’s price unexpectedly accelerates, for example, due to positive news or higher-than-expected earnings, leaving short sellers scrambling to quickly close their positions by buying back the borrowed shares. Short sellers exiting their positions drive the price of a stock up even further. The stock price momentum can also attract other investors to buy, pushing the stock’s price even more.

How do you know when a short squeeze is coming?

For a short squeeze to occur, there must already be many short positions outstanding. The more heavily a stock is shorted, the greater the chance of a short squeeze. This happened, for example, with GameStop. In the spring of 2020, the number of shorts stood at over 100%. In other words, there were more shorted shares than freely tradable shares. The American video game retailer was, therefore, an ideal target for investors to cause a short squeeze. On the online forum Reddit, private investors drove the price up by hundreds of percent, and short sellers were forced to exit their positions to limit their losses. Companies with more than 10% of their shares in short positions and a market capitalisation of less than €1 billion are most at risk of a squeeze.

In Europe, short sellers must disclose their position when it exceeds 0.5% of the issued capital. This is calculated by looking at all long and short positions in shares and derivatives in the company concerned.

What happened in Volkswagen’s short squeeze?

One of the biggest short squeezes took place in 2008 with Volkswagen. Hedge funds thought that the German carmaker would not survive the major financial crisis and speculated massively on a price drop. A large short position was built up, amounting to approximately 12.5% of outstanding shares. At the same time, rival Porsche increased its minority stake from just over 40% to 74% of Volkswagen shares through options. When this became known, short sellers fled from their positions. Within five days, Volkswagen's share price increased fivefold to €999, briefly making it the largest company in the world.

What are the risks of a short squeeze?

Taking part in a short squeeze can involves high risks. It mainly comes down to good timing. For example, during GME’s short squeeze, prices skyrocketed to $347.51 on January 27, 2021. However, a week later, on February 4, the price was already sharply lower at $53.50. This is a clear example that once most short sellers have closed their positions, the price often collapses again.

Are short squeezes profitable?

Short squeezes are quite risky, but they can be profitable. When you buy a stock at a low price and a short squeeze drives it up, if you sell at the right time, you can see a large return. However, it is impossible to time the market, and prices can fall just as quickly as they rise.

Key takeaways:

• When a short squeeze happens, the price of a heavily shorted stock unexpectedly rises, resulting in short sellers closing their positions, driving up the stock’s price even more.
• Volkswagen was one of the biggest short squeezes in history, and we saw many other short squeezes in 2021 amid the meme-stock frenzy.
• In some cases, investors can profit from a short squeeze, but it comes with high risk.

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Sources: Investopedia, FD, shortsell, The New York Times