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What Is a Short Squeeze?

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A couple looking at the Gamestop short squeeze.

A short squeeze is a rapid increase in the price of a stock resulting from a lack of supply and an excess of demand. Typically, short sellers (those who have borrowed and sold stocks they believed would fall in value) scramble to buy them back as the prices start rising, contributing to further price hikes. Understanding the dynamics of a short squeeze, its importance, and the inherent risks involved is fundamental for any investor involved in trading. In situations like these, a financial advisor could provide practical understanding and advice in navigating short squeezes for both novice and experienced investors. 

How a Short Squeeze Works

The process of a short squeeze unfolds when a stock’s price begins to climb, compelling short sellers to buy back the stock to cover their positions and mitigate their losses. This rush of buying activity elevates demand, propelling the price even higher, thus catalyzing a squeeze. 

To understand the real-life impact, consider the instance of the GameStop short squeeze in January 2021. The stock price swiftly escalated from roughly $20 to over $480 in mere days due to collective action by a group of retail investors on Reddit, causing monumental market fluctuations. This leads to why it’s so important to understand how this works. 

Importance of a Short Squeeze

Transitioning from how a short squeeze operates to understanding its implications, it’s noticeable that short squeezes can lead to considerable price swings. This is very important to anyone who has a vested interest in the stock as they could lose or gain significantly from the situation. These fluctuations don’t only affect the specific stock but the broader market indices as well, potentially attracting regulatory attention. 

A short squeeze often contributes to market volatility and implies rapid, significant price changes. For instance, the GameStop saga stirred significant swings within its own stock price and the broader market, influencing the performance of other stocks and sectors. It had a significant impact that caused many to earn money very quickly while it caused hedge funds, like Melvin Capital, to lose nearly $7 billion in as quickly as a month.

What Is Short Interest?

A couple looking at their stock that is being shorted and how it impacts their investment

Short interest signifies the number of shares that have been sold short but are yet to be covered or closed out. The higher the short interest, the more a specific stock is viewed by investors to have a negative outlook. High short interest indicates a potential short squeeze, as it implies a large number of short sellers that might need to buy the stock to close their positions. 

Short interest is generally expressed as a percentage derived by the ratio of shares sold short to the number of outstanding shares. This percentage offers investors insight into market sentiment towards a particular stock, serving as a valuable tool for predicting potential market movements.

Risks of Trading Short Squeezes

In short trading, the main risk lies in the potential for unlimited losses, as a stock’s price can rise indefinitely, and a short seller’s losses grow as the price continues to increase. This risk intensifies during a short squeeze, where the stock’s price can skyrocket for a brief period. However, with an understanding of these potential risks, working with a professional can be crucial in formulating an effective risk management strategy in such circumstances. 

Tactics like setting stop-loss orders, which essentially instruct a broker to sell a stock once it reaches a certain value or maintaining a diversified portfolio can help mitigate risks. Proactively staying informed can also shield investors from the risks of short selling and possibly leverage market volatility to their benefit.

Naked Short Selling vs. Short Squeeze

Naked short selling is an illegal practice that involves short-selling shares that haven’t been confirmed to be available. This obviously contrasts with a short squeeze, a legitimate market phenomenon where a stock’s price swells rapidly. Naked short selling can skew market prices, causing artificial price movements and disrupting the fair-price discovery process, thereby inviting penalties from regulatory institutions such as the Securities and Exchange Commission (SEC).

Bottom Line

A couple trying to decide if they should invest into a short squeeze.

Comprehending the dynamics of a short squeeze and the distinction between naked short selling and short squeeze proves vital for any sophisticated investor. Possessing a sound grasp of these principles can equip investors with essential knowledge for informed decision-making while reminding them that inherent risks are involved in the stock market. This understanding can also highlight potential investment opportunities while managing risks associated with short selling. Those risks as well as the built-in complexities of a short squeeze mean that retail investors are well-advised to consult with a financial advisor before starting to trade a short squeeze.

Tips for Investing

  • It’s important to understand any potential investment strategies before implementing one. A financial advisor can help you understand your investments and help you make the right choices for your financial goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now
  • If you want to better understand how your portfolio might perform based on your investment choices, consider using a free asset allocation calculator

Photo credit: ©iStock.com/LaylaBird, ©iStock.com/Pekic, ©iStock.com/PeopleImages

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