What is a short squeeze?

What is a short squeeze?

A ‘short squeeze’ is an unusual market event in which the price of an asset – like shares in a company – rapidly increases, causing short-sellers to surrender their positions simultaneously. This article looks at how a short squeeze can happen and what sort of things might trigger it.

A businessman tries to stop metal doors closing on him, indicating a short squeeze on a share price
Image source: Getty Images

How does a short squeeze happen? 

A short squeeze can only occur when a significant number of investors hold short positions in a company’s shares. 

Short-selling involves investors profiting from a decline in a company’s share price. It’s a trading activity typically limited to professionals. However, it’s worth understanding what it is and how it can impact share prices.

To short a stock, short-sellers will borrow shares from other investors under the condition that they will return them to those investors after an agreed period. 

Short-sellers then sell the borrowed shares on the open market, hoping they will decline in value before the end of the loan period. That way, when the short-sellers eventually have to return the shares to the lender, they can repurchase them for a lower price than they originally sold them for and pocket the difference.

The risk to short-selling is that if the share price moves in the wrong direction, short-sellers' losses can be limitless because there is theoretically no cap on how high a share’s price can rise. 

This often means that if a company’s share price begins to quickly increase (and looks set to climb further), short-sellers may be forced to cut their losses and close out their positions. In some cases, this might mean repurchasing shares at a higher price than the short-sellers originally sold them for – but it may be necessary to stem the losses.

The problem is that short-sellers buying shares in the open market to close out their short positions can increase demand for the company’s shares, helping drive the share price up even further. 

Not only might this attract new buyers, but it can also spark panic among other short-sellers, who may simultaneously decide to bail out of their positions. When a significant number of short-sellers are doing this at once, it becomes a short squeeze.

What are some examples of short squeezes? 

Many investors were introduced to the concept of a short squeeze after it famously happened to shares of US video game retailer GameStop Corp (NYSE: GME) in January 2021. There are many other examples of short squeezes in recent history, so let’s take a look at a few of the more prominent ones, starting with GameStop.

GameStop

GameStop had become a target of short-sellers due to the fact its traditional bricks-and-mortar chain of retail stores had long been struggling to compete against newer, entirely digital services. Prolonged lockdowns imposed on the retail industry due to the COVID-19 pandemic compounded the issue.

At one point, an estimated 140% of the company’s shares had been sold short – a rare circumstance in which short-sellers had borrowed shares, sold them, and then the new owners of those shares had also lent them out to other short-sellers. In essence, a huge number of investors – including some significant hedge funds – were betting that GameStop shares were heading downwards.

Much of the GameStop short squeeze was driven by users of the r/wallstreetbets Reddit, an online community of high-risk traders specialising in ‘meme stocks’ and other speculative investments. Hoping to blow up some of the hedge funds that had shorted the stock, users of the subreddit banded together to purchase shares in GameStop and push its price higher. 

Their move was so effective that, at one point in late January, a combination of new buyers and panicked short-sellers had pushed GameStop shares to a pre-market record high of more than US$500 a share. That was more than 30 times the shares’ value at the beginning of the month.  

Volkswagen Group

Another famous short squeeze involved the German car company Volkswagen. In October 2008, fellow German car manufacturer Porsche Automobil Holding announced that it had accumulated a 74% interest in Volkswagen. 

With approximately 12.5% of Volkswagen stock sold short at the time, short-sellers feared there weren’t enough remaining shares in circulation to cover their short positions. Panicked short-sellers began buying Volkswagen shares to quickly exit their positions and minimise losses.

This sharp increase in demand for Volkswagen shares fuelled a massive rise in the company’s share price. In less than two days, its shares surged from 210.85 euros to more than 1,000 euros. In fact, Volkswagen’s share price rose so sharply that for a brief period on 28 October 2008, it was the most valuable company in the world by market capitalisation.

WiseTech Global Ltd (ASX: WTC)

The history of short squeezes in Australia isn’t quite as dramatic as it has been overseas, but there are still some examples to draw from. The most notable recent ASX short squeeze involved logistics software developer WiseTech Global.

Two scathing reports on the company by activist short-selling firm J Capital, released in October 2019, criticised WiseTech’s earnings potential and claimed the company’s growth rates weren’t sustainable. This caused many investors to start betting against the company’s stock by taking out short positions. However, WiseTech’s FY22 revenues soundly beat most analysts’ projections and prompted a sharp rally in the company’s share price.

On 25 August 2021 – the day the company released its FY22 results – WiseTech shares surged higher as new investors flooded in to snap up the company’s shares, while short-sellers hurried to close out their positions. During the day’s trade, WiseTech briefly became the 27th largest company on the ASX after starting the day in 45th position.

What are the risks of short squeezes to investors? 

As you can imagine, short squeezes can make share prices incredibly volatile. Short squeezes tend to cause sharp, rapid increases in a company’s share price and are typically followed by rapid declines. In both the GameStop and Volkswagen short squeezes, the massive rise in their share prices was short-lived, with shares in both companies plummeting in the days following the main short squeeze event.

In most short squeezes, the rapid rise in share price isn’t directly related to an underlying change in the company's valuation – so it makes sense that it’s only short-term. 

Instead, the big gains are mostly driven by panic among short-sellers seeking to quickly close out their positions and other momentum traders trying to take advantage of short-term share price movements.

The main risk for average investors is that they may purchase shares of a rapidly rising company, not realising it is actually caught up in a short squeeze. If they buy shares at the wrong time, the value of their investment can quickly collapse. 

For example, while some investors did profit from trading GameStop shares in January 2021, many others latched onto the craze just before the bubble burst or held on to their shares for too long and ended up losing big when the share price fell back to Earth.

Investors can avoid the risks of short squeezes by taking a long-term investing approach and basing investment decisions on understanding a company’s actual underlying value. 

While short squeezes can be interesting to observe when they occur, getting caught up in them can be risky for the average investor. The best advice is to try and see past these short-term share price fluctuations and focus on the long-term trajectory of a company’s share price.

This article last updated in June 2022. Motley Fool contributor Rhys Brock has positions in WiseTech Global. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended WiseTech Global. The Motley Fool Australia has positions in and has recommended WiseTech Global. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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