What Is Short Squeeze? Causes And GameStop Case Study

The stock market isn’t always predictable. Sometimes, a stock’s price will surge dramatically, caused by a “short squeeze” seemingly defying logic. While what is short squeeze might sound technical, the concept became widely known during the extraordinary events surrounding GameStop (GME) in early 2021.

It’s a situation where investors who bet against a stock are forced to buy it back, creating a powerful upward spiral.

This article will explain what is short squeeze, its underlying causes, the risks involved, and provide a detailed analysis of the GameStop short squeeze, offering a clear understanding of this powerful market force.

Understanding Short Selling

To grasp the short squeeze meaning it’s crucial to first understand what is short selling. Imagine believing that the price of a particular stock is going to decline. Instead of simply avoiding the stock, you can actually profit from this anticipated drop through short selling.

Here’s how it works:

1. Borrowing Shares: You borrow shares of the stock from a brokerage firm.
2. Selling Shares: You immediately sell these borrowed shares on the open market at the current price.
3. The Goal: Your aim is to buy back these same number of shares in the future at a lower price.
4. Returning Shares: You then return the repurchased shares to the brokerage firm, pocketing the difference between the selling price and the lower buying price (minus any fees and interest).

However, short selling comes with significant risks. Unlike traditional buying where your potential losses are limited to your initial investment, the potential losses for short sellers are theoretically unlimited. If the stock price rises instead of falling, short sellers may be forced to buy back the shares at a much higher price, leading to substantial losses.

Now let’s explain what is short squeeze.

See below…

What is Short Squeeze?

A short squeeze is a rapid and significant increase in the price of a stock that primarily results from short sellers being forced to cover their short positions. This “covering” involves buying back the shares they initially borrowed and sold.

Think of it this way: if a heavily shorted stock starts to rise for any reason, short sellers face increasing losses. To limit these losses, they may decide to “cover” their positions by buying back the shares. This sudden surge in buying demand from short sellers adds fuel to the fire, driving the stock price even higher and further squeezing remaining short sellers, potentially leading to a cascade effect.

Key characteristics of a short squeeze often include:

Several key conditions and events can prime a stock for a short squeeze:

• High Short Interest Ratio: This metric, often referred to as “days to cover,” compares the number of shares sold short to the stock’s average daily trading volume. A high ratio suggests that it would take a significant amount of time for short sellers to cover their positions, making the stock more vulnerable to a squeeze if buying pressure emerges.
• Low Float: A stock with a relatively small number of shares available for public trading can experience more dramatic price swings. With fewer shares available, the buying pressure from short covering can have a disproportionately large impact.
• Positive Catalysts: Unexpected good news, such as a surprisingly strong earnings report, a positive announcement, or even just a shift in market sentiment, can act as the initial spark that ignites a short squeeze.
• The Power of the Crowd: The rise of online communities and social media platforms has empowered retail investors to identify heavily shorted stocks and coordinate buying efforts, creating the very buying pressure needed to trigger a squeeze, as famously seen with GameStop.
• Margin Calls Looming: As a shorted stock’s price rises, short sellers using margin may face calls from their brokers to deposit more funds. If they cannot meet these demands, their positions may be automatically liquidated, adding further buying pressure.

How to Spot a Short Squeeze

Identifying a potential short squeeze before it happens is the holy grail. While there’s no foolproof method, here are some clues to look for:

First, monitor short interest and keep an eye on stocks with high and rising short interest. Several financial websites and stock scanners provide this data.

Track “Days to Cover.” 

A high and increasing “days to cover” ratio is a significant indicator.

Be alert to news events, earnings releases, and even social media chatter that could be the catalysts for buying interest. While short squeezes are often driven by technical factors, be aware of the underlying fundamentals of the company. A squeeze in a fundamentally weak company may be short-lived.

Case Study: GameStop Short Squeeze

The advent of social media platforms and online investor communities has introduced a potent new dynamic. Concerted buying campaigns orchestrated by large groups of retail investors can exert substantial upward pressure on heavily shorted stocks, setting off short squeezes that might not have materialized otherwise.

This coordinated action was a defining feature of the GameStop episode, where platforms like Reddit’s r/WallStreetBets played a pivotal role.

The Pressure of Margin Calls

Short sellers typically leverage margin accounts, meaning they’ve deposited collateral to cover potential losses. As a shorted stock’s price rises, stock brokers may issue margin calls, demanding that short sellers deposit additional funds to maintain their positions. Failure to meet these margin calls can result in the forced liquidation of their short positions by the broker, adding further buying pressure and accelerating the squeeze.

The GameStop short squeeze of early 2021 remains a seminal illustration of this market phenomenon in the modern era.

The Backstory of GameStop

GameStop, a traditional brick-and-mortar retailer of video games, faced mounting headwinds due to the increasing prevalence of digital game downloads and online sales. This challenging environment led numerous institutional investors and hedge funds to establish substantial short positions against the company, betting on its continued decline.

The Emergence of r/WallStreetBets

The Reddit community r/WallStreetBets became a central gathering point for retail investors who identified the exceptionally high short interest in GameStop. Driven by a combination of profit-seeking and a desire to challenge established Wall Street norms, these investors began to coordinate their buying efforts, sharing their insights and strategies.

A Timeline of Key Events:

• Growing Awareness: Retail investors on r/WallStreetBets increasingly discussed GameStop’s high short interest and the potential for a squeeze.
• Building Momentum: As more individual investors bought GameStop shares, the stock price began a gradual ascent.
• The Explosive Surge: In late January 2021, the stock price experienced an unprecedented and rapid surge, rocketing from around $20 per share to an intraday peak of over $480.
• Hedge Fund Turmoil: Melvin Capital, a prominent hedge fund with a significant short position in GameStop, reportedly incurred multi-billion dollar losses and required emergency financial assistance.
• Brokerage Interventions: Several popular brokerage platforms, including Robinhood, temporarily restricted trading in GameStop and other highly volatile stocks, triggering widespread criticism and allegations of market manipulation.
• Lingering Volatility: Following the initial squeeze, GameStop’s stock price remained highly volatile, eventually settling at levels significantly higher than its pre-surge valuation.

The GameStop short squeeze starkly demonstrated the potential for coordinated retail investor action to inflict substantial financial damage on even well-resourced hedge funds. It highlighted the inherent risks associated with maintaining large short positions, particularly in stocks with high short interest, when faced with determined buying pressure.

Common Mistakes in Short Squeeze Trading

Be wary of these common mistakes when venturing into short squeeze territory:

• Chasing the Peak: Jumping into a stock after it has already experienced a substantial surge significantly increases your risk of buying at the top.
• Ignoring Trading Volume: Low trading volume can make it difficult to enter or exit positions efficiently and may signal a lack of sustained buying interest.
• Over-Leveraging: The volatility associated with short squeezes can amplify losses if you are trading with excessive leverage.
• Emotional Trading: Letting fear or greed dictate your trading decisions can lead to impulsive trading and potentially costly errors.

The Bottom Line

Short squeezes are a potent reminder of the dynamic and sometimes unpredictable nature of financial markets. They highlight how technical factors and investor sentiment can create explosive price action, offering opportunities for agile traders but also posing significant risks.

Now that you know what is short squeeze, you also realize that the power of the squeeze is undeniable, but like any powerful force, it demands respect and a clear understanding of its potential impact.