The Short Squeeze Explained

The Short Squeeze Explained


This is a guest post by Helyn Bolanis: Founder,CEO,& Chief Investment Officer Corp.

You Don’t have to be an Investment Geek to Make Money with this Idea

Ever wonder why a stock or the market just takes off like a rocket, with no apparent rhyme or reason?
Me too.
Sometimes you get why it’s going up, like if an announcement was released that was favorable, the Fed’s are adding more liquidity, or that the worry over Ebola or a Middle East war has been adverted.
That makes sense.
But what about when it happens and it doesn’t make sense?

Ever hear of the term ‘Short Squeeze’?
To understand it fully, you need to understand what it means to “short a stock”.
Simply put, you make money when the stock goes down. It’s the opposite of what you usually think about when you invest in the stock market, which is that you make money when the stock goes up.
Think of Sept. 11, 2001, when the terrorists shorted the airline stocks, especially United Airlines and American Airlines. Those were the two companies whose planes where used in the cowardly act of killing innocent people.
The terrorists knew that the stock would decline, which it did (about 43% and 39% respectively). So they made money instead of losing it.

They knew the stock would decline in price, so they made money when the stock plunged. A short squeeze is a situation in which a heavily shorted stock (stock that has been declining and many people have been betting that it will continue to decline) moves sharply higher. In order not to lose everything, it forces the short sellers to close out their positions. This means they must buy the stock. The stock market is an auction, so they compete to buy which puts pressure to pay higher prices (because remember, they must buy the stock, it’s not optional). This snowballs and adds to the upward pressure on the stock. The term “short squeeze” implies that short sellers are being squeezed out of their short positions, usually at a loss.  In other words, squeeze is synonymous with forced. So the investors who have shorted the stock are forced to buy the stock, and when there is a lot of them, they run the stock up!
Each one trying to get out with as little damage as possible. A short squeeze is generally triggered by a positive development that suggests the stock may be embarking on a turnaround. Although the turnaround in the stock’s fortunes may only prove to be temporary, few of the short sellers can afford to risk runaway losses on their positions and may prefer to close them out even if it means taking a substantial loss. After all, who knows how high the stock will go.

There’s that Warren Buffet again. Contrarian investors (those type of investors that look to do the opposite of everyone else, like Warren Buffet) look for stocks with heavy short interest specifically because of this short-squeeze risk/return. To them, they know at some point in time, the stock will turn around. And when it does… look out. The pushing and shoving to buy the stock can make a mint for them, sometimes in just one day! These investors begin buying as the stock has declined a certain percentage. Of course, they are looking for good companies that are just having a setback, not a company that may be going out of business. Their risk is limited to the price paid for it, while the profit potential is unlimited.
This is diametrically opposite to the risk-reward profile of the short seller, who bears the risk of theoretically unlimited losses if the stock spikes higher on a short squeeze.

Interesting, wouldn’t you say.
I hope this helps you better understand a short squeeze.
Good luck!