The Short Squeeze Explained
It’s not uncommon to see a dramatic spike in a company’s stock price based on tepid news. This can leave the average investor baffled but the reason for this is quite simple: a classic short squeeze. A short squeeze occurs when short sellers of a company’s stock are forced to cover their short positions in the midst of positive news. More on that in a minute. Let’s review the basics of short selling.
Publicly traded companies issue shares of stock and investors buy and sell them. In some cases, investors seeking to profit from the downward movement in a company's stock will sell shares short. In other words, they borrow shares (facilitated by a broker), sell the shares, then buy them back in the future at what they hope will be a lower price. For example, suppose you sell shares of Home Depot short at $78. You have borrowed shares of Home Depot and recorded a sale at $78. Now, suppose Home Depot stock drops to $70. You could cover your short position by purchasing shares of Home Depot at $70 to replace the shares you initially borrowed. You earned $8 on your trade. What happens if the stock moves higher than $78? You suffer a paper loss on your position. If Home Depot moves to $88, you have already lost $10. If it moves to $98, you’ve lost $20. Enter the short squeeze. Companies which have heavy short interest (meaning a significant percentage of their traded shares are sold short) run the risk of a short squeeze. Given the magnitude of the short interest in these companies, it's safe to say that these companies are facing some challenges. Every now and then these companies surprise investors with a sliver of good news and their stock price climbs. This sends the short sellers into a panic causing them to cover their positions with buy orders. The flurry of activity from the short sellers creates excess demand for shares when supply may be limited resulting in a spike in the stock price. This is a classic short squeeze. Such movements are generally short lived as eventually reality sets in and investors realize that the company still faces challenges.
So how does a short squeeze affect Main Street? Main Street investors should know the risks of buying or selling shares in a company with heavy short interest. If you buy the shares, you should be aware that quick spikes may be driven more by short sellers covering their positions as opposed to long term investors buying a stake in the company. And if you sell shares short in these companies, be ready to cover quickly if you sense a short squeeze.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.