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Stocks


WHAT'S A SHORT SQUEEZE AND WHY DOES IT HAPPEN?




March 28, 2023 Advanced
 * 


Beware the risks of short selling before taking the plunge.


Key Points

 * A stock that rallies hyperbolically when there are no obvious current events
   driving the response, could be experiencing a short squeeze.
 * A short squeeze can potentially be worth trading, but only if you exercise
   great care.

The aim of short selling is to generate profit from a stock that declines in
value. (Short selling involves borrowing a security whose price you think is
going to fall from your brokerage and selling it on the open market. Your plan
is to then buy the same stock back later—hopefully for a lower price than you
initially sold it for—and pocket the difference after repaying the initial
loan.) While there are potential benefits to going short, there are also plenty
of risks. One big risk is when a bullish catalyst (earnings, news, technical
event, etc.) pushes the stock price higher, prompting short sellers to "head for
the exits" all at once. As the shorts scramble to buy back and cover their
losses, upward momentum can build on itself, causing the stock to move sharply
higher. This is known as a short squeeze.


UNDERSTANDING THE SHORT SQUEEZE

What makes a short squeeze so dangerous? Think of it this way: When you buy a
stock, the worst thing it can do is drop to zero. But the upside is unlimited.
If a stock has a growth narrative and there are enough believers, the share
price can go well beyond what looks reasonable by traditional fundamental
metrics.

Classic signs of a short squeeze can include:

 * A security has a significant amount of short sellers (short interest) who
   believe the stock price is going to fall, and then instead the stock price
   sharply rises, forcing many of these leveraged short sellers to quickly exit
   their positions, buying back the stock in the face of potentially increasing
   losses.
 * A dynamic narrative that tries to justify the detachment of share prices from
   a company's intrinsic value
 * A case for massive growth as well as for financial stress
 * Traders with deep pockets aligned on both sides of the trade, often using
   options and other leveraged instruments

With GameStop (GME) in 2021 and Tesla (TSLA) in 2020, there were many classic
signs of a short squeeze. Traders with short positions were covering because
they had to, either because they had sustained large losses or shares were no
longer available to be borrowed. In 2022, short sellers targeted troubled
companies such as Bed, Bath & Beyond (BBBY) and Carvana (CVNA). In early 2023,
the most heavily shorted companies included Coinbase Global (COIN), a
cryptocurrency firm, and Occidental Petroleum (OXY).

When a stock suddenly experiences a dramatic climb, with or without good news,
it's important to ask yourself, "Who would buy shares up here?" The answer?
Someone who doesn't have enough money to hold on any longer, or someone whose
pain threshold has finally been crossed.


PROCEED WITH CAUTION

If you're a long-term investor who happens to own a stock that's getting
squeezed, it's probably not a good time to trade. Instead of acting on emotions,
remember what got you to where you are in your investing journey—and where you'd
like to be. If buying a stock that's in squeeze territory doesn't fall within
your long-term objectives, you might want to step aside and not trade. If you do
decide to venture in, make sure you have no illusions and no misconceptions of
the dangers. Understand that when you’re dealing with a stock that’s being
squeezed, you're taking a big risk. 

Identifying a short squeeze can be relatively simple—after the fact. The trick
is to identify the conditions that could lead to a squeeze ahead of time, and
then determine how you might want to play it (or not). 

Shorting a stock is a complicated business. Because you can't sell something you
don't own, shorting requires the seller to "borrow" the stock (and pay interest
to the stock lender), then sell it. Locating the shares can sometimes be
difficult for your clearing firm because of high demand or a small number of
outstanding shares.

Measuring a short squeeze can involve a metric called the short interest ratio,
a.k.a. "days to cover." It indicates, in days, how long it would take to cover
or buy back all the shorted shares. Basically, you divide the number of shares
sold short by the average daily trading volume. The more days to cover, the more
pronounced the effect can be.

Another measure is "short interest as a percentage of float," which reflects the
number of short-sold shares in proportion to the total number of shares
available for trading in the public markets. Most stocks have a small amount of
short interest, usually in the single digits. The higher that percentage, the
greater the bearish sentiment may be around that stock. If the short % of the
float reaches 10% or higher, that could be a warning sign.


CONSIDER THE FUNDAMENTALS

If you're buying a stock that seems to be in the throes of a short squeeze,
especially at high levels, it helps to understand other potential reasons why
the stock might be moving. 

Consider checking the fundamentals. Is there anything that would make you want
to own the stock? Are you tempted to buy it because everyone else is? It's
important to always do your homework, and remember it's never wise to go all in.
A stock that's in a short squeeze may still have a long way to climb, and if you
don't think the fundamentals support higher prices, then perhaps you should look
elsewhere.

In the case of TSLA in 2020, there were some positive fundamentals underlying
the short squeeze, including the company's more consistent profitability and
hopes of it being included in the S&P 500 Index (SPX). The stock saw its share
price run up to new highs, then decline nearly 60%. 

But then TSLA rallied again and split its shares, and its addition to the SPX
became a reality, illustrating that a short squeeze doesn't always have to end
badly. Other stocks that were caught up in short squeezes haven't always fared
so well, in part because they didn't have the fundamental support. 


PLAYING THE SQUEEZE ON THE LONG SIDE?

If you want to trade a stock during what might be a short squeeze—that is,
buying a stock with a higher short interest in order to potentially play the
upside of a squeeze—here are some things to consider:

 1. Trading such a stock may be okay as long as you understand the risk and how
    to control it. Whether you make small or large trades, you have to control
    and limit the risk. Decide how much money you would be comfortable losing in
    any trade ahead of time.
 2. Don't underestimate how high the stock can go and how long it can take. When
    a stock gets caught up in a short squeeze, analysts generally expect it to
    correct eventually, but no one knows to what price and when; if it happens
    at all. 
 3. If the stock still has very weak fundamentals, yet is moving significantly
    higher without any real, structural changes in the corporation, then be
    extremely careful buying on this type of upward momentum. The markets may
    run out of new buyers willing to pay higher and higher prices and the stock
    may in the end fall quickly. 


THE BOTTOM LINE

A short squeeze is a high-risk situation and it may cause havoc in the market,
but most don't last forever. Most eventually subside.

JUST GETTING STARTED WITH STOCKS?


Learn the basics


MORE FROM CHARLES SCHWAB

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MANAGING CASH-SECURED PUTS FOR INCOME STRATEGIES

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stocks at a favorable price. Know what to do if the cash-secured put doesn't
work out as planned.




RELATED TOPICS

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