Short Squeeze Trading Strategy — What Is It?

Last Updated on August 17, 2022 by Oddmund Groette

There are times when the prices of stocks move as a result of what other investors are doing rather than based on the company’s underlying business fundamentals. One of such events is the short squeeze.

A short squeeze happens when there is a high volume of short positions (betting that the stock would decline), but instead, the stock’s price shoots up, forcing the short sellers to exit their positions by buying back the shares, which in turn causes the price to jump higher. A short squeeze can make the price of a relatively unknown stock skyrocket over a short period.

Want to learn more about short squeezes, keep reading!

What is a short squeeze?

A short squeeze is when a heavily shorted stock’s price goes up instead of down, forcing the short seller to exit their positions by buying back the shares at the new higher price so they can return the borrowed stocks, thereby enduring heavy losses.

Short squeezes can make short sellers lose a lot of money on their trades because unlike price declines, which are capped when the share price reaches $0, price advances theoretically have no limits.

Short squeeze example

Let’s say some investors believe that stock XYZ is overvalued at its current share price of $50, and they borrow other’s shares of the stock and sell (short selling), with the hope that the share price would drop to say $30. However, instead of the share price to drop, it rises to $65 and keeps rising, probably following a better-than-expected earnings report.

Since the short sellers would have to return those borrowed shares to the lenders, they would need to buy back the shares at the higher price. Assuming there are many short sellers who want to buy back shares before they lose even more money as the stock rises, they would have to compete with each other in a sense, because others are also clamoring to get rid of their stock. This scramble to buy the stock further pushes the share price up, and there’s no fundamental limit to how high the stock could climb as brokers initiate margin calls forcing shorts to buy to cover.

Top biggest short squeeze in history

These are the most notable short squeezes in history:

  • Volkswagen (OTC: VWAGY): In 2008, Volkswagen saw its stock price jump by more than 300% in a matter of days, briefly making the company the most valuable publicly traded company at the time. A number of factors contributed to the squeeze. One of them was that the holding company Porsche SE owned a big chunk of the shares, and the German government also owned a large stake. This meant that relatively few shares were actually traded in the public market. Moreover, there were speculations that Porsche would buy the rest of Volkswagen.
  • GameStop (NYSE: GME): In January 2021, GameStop was a relatively unknown stock that was heavily shorted by hedge funds. But its stock price rose from $17 to a peak of $483 within a month following a short squeeze event coordinated by retail investors on a Reddit.com forum called WallStreetBets. At some point, GME reached $20 billion in market cap and had more daily trading volume than AAPL. Large hedge funds such as Melvin Capital suffered 50% losses during a short period and required emergency capital injections that resulted in costly dilution.

Are short squeezes illegal?

In the U.S. stock market, a short squeeze may be illegal, depending on whether there was a manipulation of the stock price or the availability of the stock in bringing about the short squeeze.

In the words of the US Securities and Exchange Commission (SEC):

“Although some short squeezes may occur naturally in the market, a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal.”

How long does a short squeeze last?

How long a short squeeze lasts is not set in stone. It generally depends on the volume of shorted shares, the average daily trading volume in the stock, and the broker’s eagerness to recall the borrowed shares.

However, short squeezes typically don’t last long, often within 2-4 weeks. Most short squeezes last less than a month. The Volkswagen short squeeze, one of the most popular in history, took about 31 trading days to climax. The GameStop short squeeze lasted less than a month, even though the stock later rallied for several months after gaining popularity from the short squeeze.

Short Squeeze Trading Strategy

A backtest of a short squeeze trading strategy coming soon.

 

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