To understand the concept of a short squeeze, you must first understand what it means to take a short position on a stock. For some of the more seasoned investors this might be a bit of a review, however, it is always important to refresh your memory of fundamental topics when learning a more advanced one.
A short position, or short, is an investing strategy where the investor sells shares on the market that he (or she) has borrowed. Since the investor has borrowed shares, and not money, they are expected to return shares to the broker in the agreed upon timeframe. Further, an investor would do this when they believe a certain stock’s value is going to decrease over time. For instance, if an investor borrows 10 shares of a stock that is trading for $1 and instantly sells them for the $10 they are worth, they could stand to make $9 in profit if the shares fell to a price of $0.10 before they returned them. Essentially, the investor is deciding to bet against the stock, and in this scenario, they won.
Now that you understand the basic concept of a short, it is important to become aware of perhaps the biggest risk associated with short selling, a short squeeze. As outlined above, a short position is only profitable for an investor if they are correct in their prediction that the stock will decrease in value. However, what happens when they are wrong?
If a stock starts to rise rapidly, it might pressure the investor to buy back the shares and accept their loss. For instance, if the shorted stock’s value was to increase 20% in a single day, the investor might be forced to liquidate completely. Interestingly, if there are many individuals who hold a short position on a particular stock and they decide to buy back their shares at the same time, due to a rapid price increase, they might actually push the price even higher.
Conversely, there are some investors who seek out stocks that have collected heavy short interest in an attempt to initiate a short-squeeze. If these investors identify a stock that is heavily shorted and believe that the chance for growth is higher than the bearish perception, they will accumulate many shares, therefore, taking a long position. Fortunately for these investors, the risk-reward payoff is largely in their favor, especially if they got the stocks at a relatively low price. This is because their total risk is limited to the amount of money they spent on the stocks, while their potential profit is technically unlimited. In contrast, the risk-reward profile of the short seller is not so optimistically lop-sided. In this case, the short seller bears the risk of theoretically unlimited losses if the stock were to continually grow in value on a short squeeze, and would have a maximum reward of the price per share that they borrowed the stock at. Keep in mind, this maximum profit would only be realized if the stock price crashed all the way to $0.00. Otherwise, the profit amount would be the difference between the price of the shares when they were borrowed/sold and the price when they were re-purchased/returned to the broker.
Clearly, taking a short position can be a great move, but can also be extremely risky. As result, it is important that investors completely analyze a situation before jumping in and that they make sure they are comfortable with their decisions. Likewise, the difference between minor loss from calculated risk and absolute disaster can be the knowledge of when to cut-losses and move on. For a short seller, the most dangerous outcome is one where they hang-on to a stock too long and dig themselves into a significant deficit that they must buy their way out of. Henceforth, it is the duty of each investor to do their own due diligence and make the financial decisions that are best for them. Sometimes, knowing how to minimize losses is just as important as knowing how to maximize profits.