Definition and Examples of a Short Squeeze
The term “short squeeze” refers to the pressure that short sellers face to cover their positions after a sharp increase in the price of the stock they sold. When you borrow a stock and sell it immediately, hoping that the stock price will decline. If you’re right, you can buy the stock back at a lower price and return it to the owner. Your profit is the difference between the sale price of the stock and the repurchase price. If you’re wrong, your losses can often be unlimited. You will have to buy the stock back to close your position, regardless of how high the price goes. This is the short squeeze, which occurs when the price of a sold stock rises significantly. Then short sellers are forced to pay higher prices to close their positions, which adds to the upward pressure.
How Does a Short Squeeze Work?
There are no rules dictating the time limit for those who are short selling when they close their positions. However, if you short sell a stock in your account, in some cases your broker may require you to do so, meaning you must buy the stock at the current market price. This is the case with the financial services company Charles Schwab. When a stock is trading weakly or the stock is rising, this can lead to a short squeeze, as many investors are forced to close their positions at the same time.
A short squeeze can also occur naturally when stock prices jump in response to unexpected news. Let’s take a look at an example of that.
What Does This Mean for Individual Investors?
Short selling can be used by investors for many reasons, including profiting from an unexpected decline in the stock price, providing liquidity when there is unexpected demand from buyers, or hedging the risks of a long position in the same security. While most short selling is legal, there are some instances where abusive short selling practices are illegal, according to the second party. Examples of prohibited manipulation include engaging in a series of transactions to create active trading in a stock, or driving down the price of a security to influence other investors to take action.
Short selling carries high risks. Your potential losses are unlimited, but your potential gains are limited. The most you can earn is the difference between the sale price of the borrowed shares and the repurchase price. Although short squeezes of unusual stocks like GameStop, along with other meme stocks like AMC Theatres and Blackberry, gained media coverage in 2021, many stocks that are short-sold are actually declining. If that happens, those who shorted the stock are the ones making profits and regular shareholders are the ones facing severe losses. Even in the case of a short squeeze, there is no guarantee that you will be able to sell your shares for a gain, amidst significant price volatility.
If you want to discover a stock that may be prone to a short squeeze, there are key metrics you need to consider:
– Short interest: This is the ratio of shares held short. If a stock has a significantly high short ratio compared to its peers, or if it is rising rapidly, the likelihood of a short squeeze increases.
– Days to cover ratio (short interest ratio): This is the number of currently borrowed shares divided by the average daily trading volume. For example, if there are 10 million shares borrowed from a company and the average daily trading volume is 4 million, the days to cover ratio would be 2.5. This means it would take 2.5 trading days to cover all short positions. The higher this number, the greater the chance of a short squeeze.
Source:
https://www.thebalancemoney.com/what-is-a-short-squeeze-5193705
Leave a Reply