What is a Short Squeeze in Stock Trading?

Definition of a Short Squeeze:

A short squeeze happens in stock trading when the price of a stock rises quickly, continues to gain momentum, and then causes many short sellers to mitigate losses and close their positions, and forces brokerage firms to enforce risk liquidations on short sellers to ensure their accounts don’t enter negative equity. All this forces massive buying pressure onto the stock, which drives the price even further since a short position is closed through the actual purchase of the stock, unlike the selling of the stock in a long position. In this blog, we’ll discuss how short selling works, the mechanics of a short squeeze, and real-world examples of them occurring in the stock market.

What is Short Selling?

Short selling is a method in which market participants attempt to make money by speculating on a stock’s decline in price. How this works is that you would borrow the stock from a brokerage firm on margin and sell it on the open stock market. How simple it is to enter a short trade depends on what brokerage firm you’re trading at and if you are required to locate the stock before entering the short position.

Typically, you won’t have to locate stocks with a large float, such as a company in the Magnificent 7. However, with smaller companies, such as small-cap companies, there typically exists a low float on these stocks, making it more likely that you will be forced to purchase a locate from your brokerage firm before entering a short trade to ensure that you are not naked shorting. This makes having an account at a brokerage firm with access to locate sources crucial if short selling low float stocks is a valued component of your trading strategy.

Once you have entered the short position you would hope the price of the stock declines in value from the price you entered the trade at. Then once the desired amount of decline in share price occurs (if at all), you would buy the stock at a cheaper price than what you borrowed them at and return the shares back to the brokerage firm, thus profiting off the difference. All of this is done electronically of course and is much more seamless than it sounds due to advanced electronic trading systems.

For example, let’s say you thought the price of a company trading at $10 per share was going to decline in price so you felt confident that you should short the stock. If the stock did not require the purchase of a locate before entering the position and your brokerage firm was not restricting the existence of a short position in this symbol, you would borrow the shares from the brokerage firm by entering the short position at $10 per share. Then if the stock price fell to $5 per share, and you were content with this gain, you would buy the stock back at $5 per share and return the shares to the brokerage firm, profiting the $5 difference minus all fees such as commission, regulatory fees, ECN fees, etc.

Mechanics of a Short Squeeze:

Now that we know how short selling works, we can dive into the mechanics of a short squeeze. As stated in the introduction a short squeeze happens in stock trading when the price of a stock rises quickly, continues to gain momentum, and then causes many short sellers to mitigate losses and close their positions, and forces brokerage firm to enforce risk liquidations on short sellers to ensure their accounts don’t enter negative equity. How does this actually happen though, and why is it so dangerous for short sellers?

Let’s use the stock we discussed in the previous paragraph to illustrate our point. Let’s say that you short a stock trading at $10 per share, and then within 30 minutes, jumps to $17 per share. You are now sitting at a 70% loss not including any additional fees. At this point, many traders either panic close their positions or hit their risk limitations, and brokerage firms enforce risk liquidations. All of this translates to buy orders from these brokerage accounts thus increasing the price of the stock. This moves the stock mentioned earlier from $17 per share to $23 per share to $35 per share, and so on, causing massive losses and “squeezing” short sellers out of their positions along the way.

Real-World Example of a Short Squeeze:

Gamestop ($GME): In arguably one of the most famous short squeezes in recent memory, we will discuss the epic short squeeze that occurred in the stock $GME.

On December 31st, 2019, Gamestop stock closed at $6.08 per share. In July, 2020, YouTube sensation Keith Gill aka RoaringKitty began releasing videos stating that he held a long position in $GME stock and believed that the stock has been over shorted by institutional investors. Attention ramped up in November, 2020, when Ryan Cohen, an activist investor and former CEO of Chewy purchased more than 10% of $GME’s outstanding shares, and later joining the company’s Board of Directors. By the end of November, 2020, $GME closed at $16.56 per share, nearly tripling from its price at the end of 2019.

Fast forward to January 28th, 2021, and $GME stock reached a premarket high of over $500. The exponential rise of the company’s share price caused a short squeeze for numerous retail and institutional investors who held short positions in the company, with many experiencing forced liquidations and incredible losses during the short squeeze.

Conclusion

A short squeeze happens in stock trading when the price of a stock rises quickly, continues to gain momentum, and then causes many short sellers to mitigate losses and close their positions, and in some circumstances, forces brokerage firms to enforce risk liquidations on short sellers to ensure their accounts don’t enter negative equity. Short-selling is a high-risk investment and/or trading strategy and all market participants should understand the risks associated with it and assess their own risk tolerance, investment objectives, and time horizon before engaging in short-selling, as well as risks associated with Regulation SHO.

Choosing a brokerage firm that has reliable trading technology during times of high volatility, such as during a short squeeze is crucial for risk management. Just as crucial is having access to a trading platform with multiple locate sources to give you the ability to shop for locates on locate required securities at a price that is suitable for you. We encourage you to try a free demo of our hallmark trading platform, Lightspeed Trader, and see why we’re a brokerage firm trusted by active and professional traders.