Is a Short Squeeze Good or Bad? (How to Profit From It)

What is a Short Squeeze?

A short squeeze occurs when a large number of traders short a stock. If the price starts rising, many of those traders who are short will want to exit their position.

They do so by buying shares to close their position. This can happen rapidly, resulting in a sharp rise in the share price.

When a stock has been shorted, it means those shares were borrowed, and the shares must be returned to the owner at some point. Short trades are generally held for the short term, as brokers charge interest on the shorted shares (more on this below).

If many traders are short, and the price starts rising — especially if it starts rising sharply — most of those short positions will want to get out of the trade. The price is not dropping as they expected, since it’s now going up; if they continue to hold the position, the loss will get bigger and bigger, and they are also paying interest for holding the position.

These are all factors that cause shorts to exit their position. The only way to get out of the short position is to buy. As all these short positions buy, it causes the price to accelerate to the upside even more.

That event is the short squeeze. It means the shorts were squeezed by the buyers, resulting in a jump to the upside in the stock price. If “shorting” is unfamiliar to you, here is a quick summary of what shorting is and how it works.

How Shorting Works

Shorting a stock is a trading strategy in which an investor sells borrowed shares of a company’s stock in the hopes that the price of the stock will decrease, allowing them to buy back the shares at a lower price and pocket the difference as profit.

If you sell 100 shares of XYZ stock at $10, thinking it will fall, you are credited with $1000. But that money isn’t yours yet. The trade is open and must be closed at some point in order to realize a profit or loss.

If the shares drop to $8, you could buy the shares. This costs $800. You initially received $1000 for the sale. You profit $200. If the shares rally to $15, you may decide the loss is too big and exit. This costs $1500 to buy the shares. You initially received $1000. The loss is $500.

Borrowing shares is a privilege. Someone who owns the shares must lend them to you. For this, there is typically an interest charge. Generally, the more people that want to short a stock, the higher the interest cost because demand for borrowing is high. If few people are shorting a stock, the interest charge is generally quite low.

Simply put, when you invest, you typically buy a stock and sell it at a higher price. With shorting, you sell first and buy it later, hopefully at a lower price. In the financial markets, you can go in either direction.

Short Squeeze Chart Examples

Here are a few chart examples of short squeezes playing out, showing the rapid rise that can ensue.

The following charts show two of the most extreme examples of short squeezes. Most short squeezes do not result in such large upside moves. The following chart is of AMC Entertainment Holdings, Inc. (AMC):

Very sharp price rises are common in short squeezes because the shorts need to get out quickly or face even larger losses. GameStop Corporation (GME) was another massive short squeeze which even made the mainstream news in 2021.

The chart below shows the spike. While most stocks are moving down or sideways prior to a short squeeze (which attracts people to short it in the first place), that isn’t always the case. GME had been moving up for a while. When buying accelerated, the shorts were forced out at higher and higher prices.

How to Profit From a Short Squeeze

A short squeeze occurs when investors who have shorted a stock are forced to buy back shares to cover their positions, which drives the stock price up rapidly.

This can create a profit opportunity for traders who are able to identify a potential short squeeze and act quickly.

Here are some ways to profit from a short squeeze:

1. Buy the stock: If you believe that a short squeeze is imminent, you can purchase the stock before the short sellers start buying to cover their positions. This can allow you to profit from the upward price movement caused by the short squeeze.

However, timing a short squeeze can be tricky. It is hard to know exactly when the price will start rising and the shorts will start buying/covering their positions. Therefore, it is often best to wait until the price is actually rising. If the short sellers get spooked, they will start buying, helping to push the price up even more.

2. Buy call options: Call options give you the right to buy a stock at a certain price (the strike price) before a certain date (the expiration date). If you think a short squeeze is coming, you can buy call options.

As the price rises, the call option will increase in value and you can sell it at a profit. Ideally, wait for the stock price to start rising. Until the price starts rising, a short squeeze isn’t occurring.

3. Sell put options: Put options give the buyer the right to sell a stock at a certain price (the strike price) before a certain date (the expiration date). If you think a short squeeze is coming, you can sell (not buy) a put option. This is also referred to as writing an option.

As the option seller, you get an upfront payment because you receive the premium (cost of the option) paid by the buyer. If the stock price rises, the put option will become less valuable or expires worthless. This is what you want as a put option seller. You get to pocket most or all of the premium you received.

The profit is limited to the premium received. That means even if the stock skyrockets, the profit is the same. If you believe the short squeeze will be large, resulting in a significant price increase, profits will likely be bigger with buying the stock or buying call options.

How to Determine if a Short Squeeze is Likely to Occur

Short squeezes only occur in stocks that have a large number of short positions in them. Here’s how to find stocks that are heavily shorted.

There are only so many shares of a stock, and not all are tradable. Some are held by insiders or institutions which aren’t trading or selling them. The shares available for trade are called the “public float.” The amount of shares which have been sold short is available as public information.

Based on this information, traders can see how much of the share float is shorted. This is called “short interest.” The formula is: Shares Shorted / Share Float = Short Interest

A high percentage could trigger a short squeeze, but only if there are enough buyers to push the price up enough to start scaring the huge amount of short sellers. Several websites track short interest and provide the data free of charge.

At the time of writing, these are the most heavily shorted stocks in the US market – the stocks that traders are going to watch for short squeezes to possibly occur. There is also another metric you can look at called “days to cover.”

Based on the typical volume in the stock, days to cover is how many days it will take for all the short sellers to exit their positions. Because volume varies by stock, the stocks with the highest short interest may not necessarily have the highest days to cover.

If a stock does very little volume and has a moderate short interest, that stock could spike aggressively on a short squeeze because there are not many shares available for the short sellers to buy, so they must buy at higher and higher prices. Information on days to cover is also publicly available on sites such as MarketBeat.

Await Confirmation of a Short Squeeze

A high short interest doesn’t guarantee a short squeeze. Always await confirmation instead of simply hoping a short squeeze will occur.

A stock is usually heavily shorted because it has been dropping, or because there is speculation the company may fail or do poorly in the future. Solid companies with great earnings and strong growth prospects for the future are rarely heavily shorted.

There is a reason the stock is being shorted. The shorts may be correct and the price may keep falling. Heavily shorted stocks often do fall, since the shorting (selling) can actually push them down. Only if strong buying comes in — alarming the short sellers and forcing them to buy—will a short squeeze occur. There are no guarantees a short squeeze, creating a large price spike, will occur.

Therefore, it’s best to wait to buy until buying actually comes into the stock. Once buying starts pushing the price up, then consider a purchase. The rising price creates an uptrend, which is an ideal time to buy anyway. The short squeeze, if it occurs, can simply accelerate the price to the upside. Short squeezes may occur if:

• The price starts rising rapidly.
• Good news is released by the company.
• Rumors that the company is in trouble, which caused people to short in the first place, are found to be false or no longer valid.

If these types of events occur and the price starts rising, you may have found a nice short squeeze to profit from by buying the stock. “It is not the strongest or the most intelligent who will survive but those who can best manage change.” – Charles Darwin.