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Stock markets are highly unpredictable. A sudden shift in price movement (upwards or downwards) is a common phenomenon. Most of these shifts are supported by an underlying logic/news. But many times, these movements take place without any reason. One such stock market movement is called “short squeeze”, where the investors expect the price to fall but all of a sudden, the stock price starts rising, putting short-sellers in a bind.
In this article, we will be laying down a detailed description of this phenomenon along with the example of GameStop shares, and including all the important parameters that an investor should be aware of about the same.
What is a short squeeze?
A short squeeze is a term used in stock markets to indicate a sharp rise in the stock price, forcing a trader who previously sold short, to buy it and close their positions, thereby avoiding greater losses. This buying spree continues adding upward pressure on the stock price, ultimately squeezing the short-sellers out of the market.
A short-seller sells the shares presently and expects the prices to drop in future. If the price falls, they close their positions by buying the same stock at lower prices, thereby earning profits. But, if the reverse happens, they’re forced to buy at a higher price and bear a loss. Short sales have an expiration date. Therefore, an unexpected price rise stimulates the short-sellers to act fast and limit their losses.
How does it happen?
Suppose an investor identifies a stock which he believes is overvalued. With the anticipation of the prices to fall, he takes a short position. Instead, something happens (let’s say the company issues a favourable earnings report or there is some good news for its industry), and the stock price starts rising. The investor realizes that he is unable to buy the stock back at a lower price. Instead of sinking, the prices are climbing continuously.
At this point, the investor should either buy replacement shares at a higher price or buy even more shares than the investor needs in the hope of selling them for profit and covering the losses. This increased buying causes the stock to keep going up forcing even more short-sellers to make similar choices, as above.
For example, if a short seller expects the stock price of company X to fall to $80 from $100, he might short the stock presently at $100, and close his position by buying the stock when the prices are less. Several days later, if the stock price jumps to $120, the short seller would have to buy the stock at $120 and incur a loss. This phenomenon, where a short seller is buying stocks to cover his loss, is referred to as a short squeeze in stock markets.
The play behind GameStop and AMC stock rise
GameStop is an American video game and gaming merchandise retailer, the shares of which closed at under $20 per share on January 12, 2021. In around 10 trading days, a series of short squeezes occurred making the stock price jump over 15 times, eventually resulting in a stock price as high as $500. A similar trend was seen in AMC Entertainment, a movie theatre chain, where the share prices jumped ~300% on January 27, 2021, closing the same at $19.88. This was now when the users of the Reddit website subgroup Wall Street Bets began buying shares.
The unprecedented rally in these stocks made the short-sellers fall into the trap of a short squeeze. These volatile price movements were not driven by fundamental factors or news about the companies. Investors had borrowed money to support their pessimistic investment. Ultimately, they had to either pay it back by buying these shares at higher prices or risking their money to further losses.
How can one predict Short Squeezes?
- If there is a sudden uptick in the number of shares bought, it could be a warning sign of a pending short squeeze.
- Short Interest Percentage, the number of shorted shares divided by the number of shares outstanding, is another predictor to look at. A high short interest percentage means more short-sellers are competing against each other to buy the stock back if its price rises and it is more likely for a short squeeze to build.
- Check the Short Interest Ratio, i.e., short interest divided by the average daily trading volume of the stock. For example, if you short 200,000 shares and divide it by the average daily trading volume of 40,000 shares, it would take five days for short sellers to buy back their shares. A higher ratio indicates a higher likelihood of short-sellers driving the price up. A ratio of five or better is a good indicator that short-sellers might panic, and it is a good time for a short squeeze.
- Daily Moving Average Charts showcases where a stock has traded for a set period. Looking at a 50-day (or longer) moving average chart will show whether there are peaks in a stock’s price.
Betting on a Short Squeeze
- Contrarian investors may buy stocks with heavy short interest in order to exploit the potential for a short squeeze.
- Active traders may monitor highly shorted stocks and watch for them to start rising. If the price begins to pick up momentum, the trader can jump in to buy a short squeeze and start gaining from a further rise in price.
Risks of Trading Short Squeezes
- There are many stocks that moved higher after they had a heavy short interest. But there are also many stocks that are heavily shorted and keep falling in price.
- A heavy short interest indicates that many people are expecting a price drop. It does not mean a price increase. Therefore, any trader who buys with the hopes of a short squeeze should have other and better reasons to think about the price rise.
Protecting yourself against a short squeeze
- Place stop-loss or buy-limit orders on your short positions to curb the damage.
- Hedge your short position with a long position, i.e., buy the stock (or an option to buy the stock) to take advantage of rising prices.
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