What is a short squeeze? The general rule of making money in the stock market has always been buy low and sell high. However, certain entities and traders employ a strategy known as shorting a stock. Due to the complex and many times risky mechanics of shorting an index or security, few parties ever engage in what is known as a short sale. How do the mechanics of a short sale contribute to the market phenomenon of a “short squeeze”?
To understand a short squeeze it is important to understand the mechanics behind the shorting of a stock. In order to short a stock, you cannot own the equity you hope declines because if you do you just bought the stock at a higher price than you sold it at: you lost money. However, it is possible to borrow the stock from your broker dealer to achieve a radically different effect. Consider a savy trader who wants to short ABC Industries. ABC’s stock price is currently at 100 dollars. The trader believes that the stock will decline in value in the future so he or she rents 1 share of ABC from the broker dealer and immediately sells the stock to someone else in the market. The hope is that the trader can purchase the stock back at less than 100 dollars he or she bought it for and keep the difference in price as profit. However, the difficulty comes if the stock moves against the short trader. ABC Industries can only go down from 100 dollars to zero, however its return potential is limitless, meaning those who short the stock have almost infinite downside or loss potential. If ABC Industries moved up to 120 dollars per share, the short seller would be theoretically forced to buy the stock back for $120, and return the borrowed share. Netting losses of 20 dollars in addition to the cost to rent the stock from the broker dealer.
Shorts take time to unwind as they are fairly complex financial transactions. The short squeeze creates a meteoric rise in equity price due to the scarcity of the security being squeezed and the many parties who have to purchase the security either to mitigate losses or hedge against loss. Those who hope to corner the market in a heavily shorted, fairly illiquid equity can exploit this reality. The smaller the market cap, the better for the attempted short squeeze as fewer shares mean a decreased volume in the stock. Anything that is scarce and highly sought rises in value. Those who need to buy the stock to cover their positions (short sellers) are quickly at the mercy of those who own the stock outright. Remember, short sellers borrow shares from the broker dealer and have to buy the security back on the open market in order to unwind their trades.
The final factor which adds to the veracity of a short squeeze is known as dealer gamma. Those who are attempting to create a short squeeze often will use options to leverage their positions. Essentially, using 10 dollars to buy 100 dollars’ worth of a selected security. The broker dealer, in order to protect themselves and hedge the trade (in addition to meeting regulatory requirements) is forced to purchase the security as well. This tri-fecta of buyers, two of them forced, creates a buying frenzy in the fairly illiquid security that without intervention sends the security price to the moon.