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What is the Short Squeeze?

Views 23KAug 9, 2023
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Key Takeaways

The story of GameStop was dubbed an "epic short squeeze" in January 2021.

If the share price rises instead of falls as short-sellers expected, those with short positions would lose money and even be forced to close their positions. When short sellers have to buy back shares to cover their shorts continuously, the demand for the stock would exceed the supply, driving the price even higher. This situation is known as the "short squeeze".

You might have heard about the story of GameStop if you started investing in stocks before 2021.

In January 2021, GameStop (GME), a consoles retailer in America, was heavily shorted by many hedge funds due to its non-profitability and the pandemic.  

Yet shortly after, a user on the Wallstreetbets, a Reddit message board, urged retail investors to buy in GME, pushing its share price up against aggressive short-sellers.

The frenzy climaxed when numerous celebrities, notably Elon Musk, expressed their support for the movement on Twitter.

Apart from GME, other heavily-shorted stocks, including Theatres (AMC) and Blackberry (BB), also saw their share prices surging.

On January 28, 2021, GME's share price spiked to a peak of over $483, roughly 190 times the lowest $2.57, costing the hedge funds billions of dollars. So this movement was dubbed an "epic short squeeze" by the media.

As noted, a short squeeze usually occurs after a stock's price has been falling for some time. More and more short sellers are drawn to the falling prices as they seek to benefit from them. However, a big risk for short sellers is that if at some point, the market starts to see significant buying pressure. This could be from a positive news story, a product announcement, or an earnings causes it.

It might involve a piece of unexpectedly positive stock-related news, such an extremely encouraging earnings report that substantially exceeds market analysts' predictions. Another possibility is that technical traders start buying the securities as soon as they notice signs that it has been oversold and may soon reverse to the upside.

Short sellers start to lose money, or even worse, their profitable positions start to convert into losing ones, as soon as the new purchasing pressure that has entered the market increases to the point where it starts quickly driving the stock price higher.

This may prompt them to unwind their short positions by buying back their shorts and covering them out of concern that the stock will continue to rise. By placing buy orders to close out their positions, previous short sellers are adding fuel to the buying fire, potentially luring other buyers and raising the stock's price even higher.

More short sellers are eventually driven out of their market positions as the stock price rises.

This situation is known as the "short squeeze".

*Remember, when short selling, there is no limit on how high a stock price could rise so the potential loss is unlimited. Other risks include dividend risk and margin risk, this strategy is not appropriate for all investors.

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