In the stock market, a short squeeze is a situation in which a stock’s price increases significantly due to the rush of buying activities among short sellers to cover their short position.
To understand short squeeze, you must know the followings;
Short-sellers borrow stocks from stockbrokers that they believe will drop in price. After borrowing, they buy the same number of stocks when it falls up to a level of their expectations.
However, there is no guarantee that the share price will move as expected. If they are right, they will be able to buy at a low price to return stocks to borrowers.
Instead, if the market moves against their expectation, they will be forced to buy the stock at a higher price than the original short sell transaction price, resulting in a loss.
An increase in the market price of stock causes short-sellers to buy back borrowed shares from the open market to close out their short position.
Buying by short-sellers further increases the share price. It also forces more short sellers to cover their position to avoid further losses.
This rush of buying activity among short sellers due to the increase in price is known as a short squeeze.
As a general rule to trading, securities with high short interest experience a short squeeze.
Suppose many traders have taken a short position on company ABC limited from Rs 100 due to bad corporate earnings.
If the stock is trading below Rs 100, traders will wait for a further decline in share price until they reach their expected price to make a profit. However, ABC Limited announces a major client acquisition which can double its sales, due to which, share prices started moving up.
Now due to this news, many investors and traders started buying the stock of ABC Limited, resulting in a rise in the share price.
When the stock price moves up, many short sellers will be interested to cover their short position on ABC limited.
When more short-sellers participate in covering their short position on ABC limited, buying pressure is created on the stock which increases the price further.
This rush of buying ABC company’s stock among short sellers due to the increase in share price is known as a short squeeze.
Short traders’ scramble to buy only adds upward pressure on the stock’s price.
Therefore, a short squeeze accelerates a stock’s price rise as more number of short sellers try to cover their short position due to price rise.
In other words, the situation of panicked buying of stocks by short-sellers is known as a short squeeze. Due to the high price rise, short-sellers are squeezed to get out of their short position, usually at a loss.
Risk of a short squeeze in the stock market
In Investing, you buy stocks at a low price and sell them many years down the road for a higher price.
We have many different types of market participants in the stock market.
Traders who want to take advantage of the downward trend consider short selling stock as profitable. However, the stock market is very volatile.
Instead of a decline in price, if the opposite occurs and stock price starts rising, you lose money. If stock price double from the original sort sells transaction price, then you lost your entire money. If it goes further up and you did not cover your short position, then the chances of losing are huge. That is why in short selling your losses are limitless.
Whereas in investing, you can lose up to 100% of the capital invested not beyond that as the stock price will not fall below Rs 0, and your profit is limitless.
The risk of short squeeze can be measured by identifying short interest and the short-interest ratio. Few experienced investors and traders buy stocks with heavy short interest to take advantage of a short squeeze.
Do not get confused between short squeeze and short covering, both are different. Short covering is purchasing stock to cover an open short position. You cover your short position when the stock price moves up or falls. Short squeeze happens only when the stock price moves up from the transaction cost and the number of short-sellers participate in buying which ultimately forces other short sellers to squeeze their position.