What is a Short Squeeze?
Short squeeze is a term used to describe a phenomenon in financial markets where a sharp rise in the price of an asset forces traders who previously sold short to close out their positions. The strong buying pressure “squeezes” the short sellers out of the market.
A short squeeze often feeds on itself, sending the asset’s trading price even higher and forcing more short sellers to cover their positions.
As traders who previously sold short the asset must buy to cover their positions, the closing out of their short trades simply adds more buying pressure to the market, thus further fueling a rise in the asset’s price.
- A short squeeze is a phenomenon that occurs in financial markets when short sellers of a security are forced out of their positions by a sharp increase in the security’s price.
- Short squeezes are typically triggered either by unexpected good news that drives a security’s price sharply higher or simply by a gradual build-up of buying pressure that begins to outweigh the selling pressure in the market.
- As short sellers begin to exit their positions, it adds more buying pressure in the market, which can cause the price to rise even higher, forcing more short sellers to cover their positions.
How a Short Squeeze Unfolds
A short squeeze typically unfolds after a stock’s been declining in price for some time. The decline in price attracts more and more short sellers looking to profit from the fall in price. At some point, considerable buying pressure begins to enter the market. It is usually the result of one of two things.
It can be an instance of unexpected good news regarding the stock, such as a very favorable earnings report that far exceeds the expectations of market analysts. It can also be that technical traders begin buying the security as they see indications that it is oversold and, therefore, possibly ripe for a reversal to the upside.
When the new buying pressure that’s entered the market builds to the point where it begins to drive the stock’s price sharply higher, short sellers begin to see their profits erode – or even worse, their profitable positions begin turning into losing positions.
Fearing that the stock will continue its upward move, they move to exit their short positions with the necessary buy order. As previous short sellers enter buy orders to close out their positions, it adds fuel to the buying fire, attracting more buyers and pushing the stock’s price even higher.
As the stock’s price continues to rise, more short sellers are gradually squeezed out of their market positions.
How to Spot an Impending Squeeze
Technical traders monitor certain indicators that may reveal that a stock is ripe for a short squeeze to occur if substantial buying pressure begins to enter the market.
One is the short interest – the percentage of a stock’s total number of shares that are currently held by short sellers. When the percentage of the stock’s total shares that are currently sold short is significantly higher than the normal level, the likelihood of short squeeze is considered to be increased.
Another technical indicator that traders monitor is what is known as “days to cover.” It is a metric derived from comparing the total short-selling interest in a stock to its average daily trading volume.
The computation indicates the theoretical number of days, assuming average trading volume, that it will take for those who sold short to cover – exit – all of their positions. The higher the days to cover number is, the more prone the stock will be to a short squeeze.
Technical traders also look at indicators such as the Relative Strength Index (RSI), which are intended to indicate overbought or oversold conditions in a market. A market is considered to be oversold when the RSI reading is below 20.
Technical traders view the situation as indicating that the market may be due for an upside reversal in price movement. If the security’s price begins to rise, they will start buying it. If there is enough buying interest, short sellers may begin to get squeezed out of their positions.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: