Short squeezes: Everything you need to know about the recent investing movement

About Latest Posts Matthew Frankel, CFP Latest posts by Matthew Frankel, CFP (see all) Short squeezes: Everything you need to …

| More on:

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Have you noticed something strange going on in certain stocks recently? Take GameStop. Not only has the stock more than quadrupled in January alone, but on Monday, Jan. 25, GameStop opened about 50% higher than its Friday closing price and briefly rose by more than 115% before sharply retreating to close up by "only" 18%.

Obviously, this level of volatility is highly unusual. The recent price action in GameStop and several other stocks can be attributed to a phenomenon known as a short squeeze. Here's a closer look at what that means, how it works, and why it can cause massive spikes in stock prices like we've seen this week.

What is a short squeeze?

There are hundreds of factors that could potentially move a stock's price, but on a short-term basis, stock prices are functions of basic supply and demand. If more shares are available for sale than people are willing to buy, the price will go down until enough buyers are interested. Conversely, if there are more investors who want to buy shares than the market can accommodate, the stock's price will move higher until enough shareholders are willing to sell shares to all of the interested buyers. The latter is the basic idea underpinning a short squeeze — but more on that later.

Short interest

Short squeezes are most commonly seen in stocks that have a lot of short-sellers betting against them. You can find this by looking up a stock's short interest, which is often included in a long-form stock quote you get from your broker.

Short interest is typically updated at the end of each month and tells you the quantity of shares sold short as a percentage of the stock's float, or the number of shares that are actually available to trade. For example, if a company has a float of 10 million shares and 2 million shares are currently sold short, it would have a short interest of 20%. 

Here's why hedge funds and other investors frantically try to cover short positions when stocks rocket higher like this. Let's say that you short 100 shares of a stock at $20 a share, meaning that the maximum you can profit is $2,000 if the stock goes to zero. If the stock goes to $40, you've lost $2,000, or 100% of what you hoped to make. If it goes to $60, you've lost 200%. And if it goes to $100 or more…well, you get the idea. The loss potential when a short position goes the wrong way is unlimited and can cost some of these large short-sellers billions. That's why we're seeing desperate buying in GameStop, AMC, and some of the other heavily shorted stocks that are spiking higher.

What's "normal" for short interest depends on the company, the overall economic environment, and several other factors. But generally, a short interest in the double digits indicates that there is quite a bit of pessimism about the stock. Here are a few stocks that currently have high short interest and some with relatively low short interest for comparison's sake.

Company (Symbol) Short Interest (12/31/20) Company (Symbol) Short Interest (12/31/20)
GameStop (NYSE:GME) 140.3% Apple 2.1%
Tanger Outlets 49.6% Microsoft 1.9%
Bed Bath & Beyond 37.2% Amazon 0.8%
AMC Entertainment 53% Procter & Gamble 0.6%

Data source: TD Ameritrade.

Notice that all of the stocks on the left have been behaving very strangely in terms of rapid up-and-down movements in the recent short-squeeze environment. Those on the right haven't been unusually volatile.

How a short squeeze happens

Here's the basic idea of how a short squeeze happens:

  • A stock is heavily shorted due to investor pessimism. For example, AMC Entertainment has been heavily shorted because many investors believed the movie operator wouldn't be able to survive the disruptive effects of the COVID-19 pandemic.
  • Some event happens that creates optimism in the stock. This could take the form of actual company news, broader economic developments, or some other update. For example, AMC recently announced that bankruptcy was effectively "off the table" after raising fresh capital.
  • Shares rise in response to the good news. As a result, short-sellers suffer losses, which could lead to margin calls (brokers forcing investors with short positions to either deposit more money or close out their positions).
  • Because covering a short position involves buying shares, this creates even more demand for the stock. The price moves even higher, and more short-sellers are forced to close their positions.

For stocks with truly massive amounts of short interest relative to the volume of available shares, this effect can snowball for some time, leading to tremendous volatility and huge spikes in the share price. Looking at GameStop's short interest, it's no wonder why the stock has been so reactive to the recent wave of short squeezes.

The Foolish bottom line

One important thing for long-term investors to keep in mind is that a short squeeze has nothing to do with the long-term investment thesis. It can certainly be nerve-racking to deal with such high volatility, but it's important to tune out the noise and focus on the long-term case for owning the stock.

Matthew Frankel, CFP owns shares of Apple and Tanger Factory Outlet Centers and has the following options: short February 2021 $140 calls on Apple. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Amazon, Apple, and Microsoft and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. The Motley Fool Australia has recommended Amazon and Apple. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on International Stock News

Digital rocket on a laptop.
Broker Notes

Is the Nvidia share price on course to reach US$1,400?

You betcha, says one analyst.

Read more »

A woman holds a soldering tool as she sits in front of a computer screen while working on the manufacturing of technology equipment in a laboratory environment.
International Stock News

Could Nvidia become the most valuable stock on earth?

Can anything stop the Nvidia stock price?

Read more »

A group of young ASX investors sitting around a laptop with an older lady standing behind them explaining how investing works.
International Stock News

What can ASX investors learn from Warren Buffett's latest buys and sells?

We've just found out what Buffett's been buying and selling recently.

Read more »

electric vehicle such as Tesla being charged at charging station
International Stock News

Why Tesla stock tanked in January

Will the electric vehicle leader see earnings decline once again in 2024?

Read more »

A woman sits at her computer with her hand to her mouth and a contemplative smile on her face as she reads about the performance of Allkem shares on her computer
International Stock News

Will Nvidia stock be worth more than Microsoft by 2030?

The graphics giant has been growing at a much faster pace than Microsoft, but can it sustain that momentum?

Read more »

Man with hands in the middle of two items with money bags on them.
International Stock News

Stock-split watch: Is Tesla next?

Stock splits are fun. But how much substance there is in Tesla splitting its stock is debatable.

Read more »

A male investor sits at his desk looking at his laptop screen holding his hand to his chin pondering whether to buy Macquarie shares
International Stock News

Yes, Microsoft is a star AI stock, but this is what really powered its solid second-quarter results

Deep involvement with artificial intelligence (AI) has made the company popular with investors, but that isn't (yet) the top motor…

Read more »

Search toolbar with a finger pointing to it.
International Stock News

Why Alphabet stock was sliding today

Shares of the tech giant pulled back on weaker-than-expected ad revenue in its fourth-quarter report.

Read more »