What Is A Short Squeeze In Trading?

What Is A Short Squeeze In Trading?

The financial markets can be home to interesting trading patterns. Sometimes, the price of an instrument skyrockets with seemingly no clear prior warnings. In stock trading in particular, a heavily shorted stock that is not particularly popular among investors may experience rapid capital appreciation in a very short time span. This phenomenon is called a ‘short squeeze’ and happens when market participants start buying up a heavily short-sold asset, which drives the price up and forces other traders to buy back their short positions at higher prices, which further adds to the upward momentum. 

A notable example of this could be observed in 2020-2021, when the prices of GameStop, AMC, Bed Bath & Beyond, and other retail stocks exploded into action, causing billions of dollars in losses to institutional short-sellers. 

Short squeezes can bring massive profits to some traders, while wiping out the portfolios of others. If the conditions become too severe and threatening to market stability, brokers may halt trading on the instrument in question, until further notice. 

If you are a beginner trader and would like to know more about what a short squeeze is and how it works, this Investfox guide is for you. 

How A Short Squeeze Works

A short squeeze is a phenomenon that occurs in the financial markets, particularly in the stock market, when there is a rapid increase in the price of a stock that has been heavily shorted.

The main components of a typical short squeeze are:

  • Short Selling - Short selling is a trading strategy where an investor borrows shares of a stock and sells them on the open market with the expectation that the stock's price will fall
  • Short Interest - Short interest refers to the total number of shares of a stock that have been sold short and not yet covered
  • Squeeze - As the stock price rises, short sellers may face increasing losses, and to limit their losses, they may need to buy back the borrowed shares at a higher price
  • Buying Pressure - As more short sellers rush to cover their positions, the demand for the stock increases, creating a cascading effect
  • Feedback Loop - The rising stock price forces more short sellers to cover, creating a feedback loop of buying pressure and price increases
  • Margin Call - Short sellers often use borrowed money to execute their short trades. If the stock price rises significantly, it may trigger margin calls, where brokers require short sellers to deposit additional funds to cover potential losses

Short Squeeze Example - GME

As already mentioned above, a notable example of a short squeeze occurred in 2020 and 2021, when a popular stock trading subreddit identified major short interest in the stocks of GameStop, AMC, Bed Bath & Beyond, and a few others. 

Once the traders started buying these shares, more and more participants entered the market to capitalize on the upward momentum, which resulted in devastating losses to institutions, who had shorted many retail companies with an expectation that their business models were outdated and the stock would eventually fall even further. 

To cover their positions, these funds and institutions were forced to buy back at higher prices, which resulted in a cascading effect on the stock, dealing billions of dollars in losses to the short-sellers. 

We can see the effects of the GME short squeeze on the chart below:


As we can see, the price shot up dramatically in 2021, which came as a huge surprise for most market participants, as news of GameStop’s struggling brick and mortar business model had been circulating for years. 

Long after the short squeeze, GME is still trading considerably higher than it was before the squeeze occurred, returning a net gain for even the most conservative shareholders of the company. 

Key Takeaways From What Is A Short Squeeze In Trading

  • A short squeeze is a market phenomenon that happens when the price of an instrument that has a lot of short interest starts to rise and triggers margin calls for short-sellers
  • Those who shorted the stock face losses as their negative bets turn against them, which can quickly spiral out of control
  • A notable example of a short squeeze occurred when the price of GameStop surged in 2021 
  • The rush to cover positions amplifies buying demand, triggering a cascade effect and leading to a volatile surge in the stock's value

FAQ On What Is A Short Squeeze

How does a short squeeze work?

A short squeeze occurs when a heavily shorted stock's price rises, forcing short sellers to cover their positions by buying shares. This increased buying pressure leads to a feedback loop, causing a rapid surge in the stock's price and potential losses for short sellers.

Can you make money during a short squeeze?

Yes, investors can make money during a short squeeze by buying a heavily shorted stock early in the process and selling it later at a higher price. However, timing is crucial, as short squeezes can be volatile and unpredictable.

Why did the GME short squeeze happen?

The GameStop (GME) short squeeze in early 2021 was triggered by retail investors coordinating on social media platforms, such as Reddit's WallStreetBets. They collectively bought GME stock, causing short sellers to cover positions, resulting in a dramatic price surge.