What is a short squeeze? Understanding why they happen and how they work

• A short squeeze is when a shorted stock's price rises and sellers close their position to avoid a loss.
• Signs of a short squeeze include frequent buying of a high number of shares being sold short.
• Buy-limit orders and hedging strategies offer short-sellers some protection against a short squeeze.

A short squeeze is a stock market phenomenon, something that happens to investors and traders who have acted on the assumption that an asset (a stock, usually) is going to fall - and it rises instead. Here's how it happens.

What is a short squeeze?

Shorting a stock involves borrowing the stock, usually from a broker, and selling it now in hopes of buying it back later for less in order to make a profit.

A short squeeze is when a shorted stock's price goes up instead of down, forcing the short seller to decide between covering their position by continuing to pay interest on the borrowed shares in hopes the price will go down or exiting their position by buying shares at the new higher price and returning them at a loss.

Quick tip: Additional pressure on the short seller can come from the original owner (broker) of the stock who can force the trader to return the stock at any time.

The downsides of a short squeeze are significant, making shorting a stock a very risky strategy for all but the most experienced traders.

Gamestop short squeeze example

In late January 2021, shares of a company called GameStop (GME) stock, which had been trading around $2.57 per share, suddenly shot up, eventually as high as $500 - when users of the Reddit website subgroup Wall Street Bets began buying up shares.

This was bad news for short-sellers, who had bet the stock would keep falling. Unlike most investors, who want their stocks to appreciate, short-sellers make money when stock prices go down and lose money when they go up.

So when GameStop started gaining, these short-sellers were caught in what's called a short squeeze. They had borrowed to support their pessimistic investment, and they now had to pay it back - by buying GameStop shares at the higher prices. Or else, hang on - and risk losing even more money.

As of mid-July 2021, GME hovered around $185 per share. While a majority of Markets Insider analysts have a Sell rating on the stock, it held up well on July 19, 2021, during a selloff sparked by an increasing number of cases of the delta COVID variant. Even then GME closed up 2.6%.

Quick tip: If you want to know more, a GameStop analyst shares how you can successfully spot a short squeeze.

How does a short squeeze happen?

Here is how a short squeeze scenario unfolds:

1. You identify a stock you believe is overvalued and take a short position. Borrowing and selling shares at today's high price in anticipation the price will go down and you will be able to buy replacement shares at a much lower price.
2. Instead, something happens causing the price of the stock to start going up. That "something" can be the company issuing a favorable earnings report, some sort of favorable news for its industry - or simply many other investors buying the stock (as happened with GameStop).
3. You realize you're unable to buy the stock back at a low price. Instead of sinking, it's climbing - and it exceeds the price you bought it for. At this point, you must either buy replacement shares at a higher price and pay back your broker at a loss, or buy even more shares than you need - in hopes that selling them for profit will help cover your losses.
4. All this increased buying causes the stock to keep going up. This forces even more short-sellers like yourself into a tighter vise. You have the same choices as above, only the stakes keep mounting, and so do your potential losses.

Protecting yourself against a short squeeze

There are specific actions you can take to try to protect yourself against a short squeeze or to at least alleviate its grip.

• Place stop-loss or buy-limit orders on your short positions to curb the damage. For example, if you short a stock at $50 per share, put in a buy-limit order at a certain percentage (5%, 10% or whatever your comfort level is) above that amount. If the shares rise to that price, it'll automatically trigger a purchase, closing out your position.
• Hedge your short position with a long position.You can also buy the stock (or an option to buy the stock) to take advantage of rising prices. Yes, you're betting against yourself, in a way, but at least you lessen the damages of the losses and benefit from the price appreciation.

Short squeeze indicators

Short squeezes are notorious for descending quickly and unpredictably. Still, there are signs a short squeeze may be coming:

• Substantial amount of buying pressure. If you see a sudden uptick in the overall number of shares bought, this could be a warning sign of a pending short squeeze.
• High short interest of 20% or above. "Short interest" is the percentage of the total number of outstanding shares held by short-sellers. A high short interest percentage means a large number of all a stock's outstanding shares are being sold short. The higher the percentage, the more likely a short squeeze may be building.
• High Short Interest ratio (SIR) or days to cover above 10. SIR is a comparison of short interest to average daily trading volume. It represents the theoretical number of days, given average trading volume, short-sellers would need to exit their positions. The higher this number, the more likely a short squeeze is coming. Both short interest and SIR are on stock quote and screener websites such as FinViz.
• Relative Strength Index (RSI) below 30. RSI indicates overbought or oversold conditions in the market on a scale of 0 to 100. A stock with a low RSI means it's oversold - that is, trading at a very low price - and possibly due to increase; a high RSI indicates the stock is extremely overbought - trading at a high price - and possibly due to drop. Any RSI below 30 signals an imminent price rise, which could lead to a short squeeze. A company's online stock listing usually includes its RSI, often under its Indicators section.

The financial takeaway

A short squeeze is bad news for short sellers and good news for investors going long. The "squeeze" forces short sellers to buy, raising the price of the stock, which causes them to lose money. Investors (buyers) benefit as the stock price goes higher. As more short sellers exit, the price goes higher causing short sellers to lose more and buyers to gain more.

Watch for any of the indicators that a short squeeze may be coming, which includes increased buying pressure, high short interest, days to cover above 10, or an RSI below 30. Most of all, you should understand that the possibility of a short squeeze makes short selling risky. Don't go there unless you understand and accept that risk.