- Short sellers are people betting against the stock
- High demand for an asset causes its price to skyrocket for a brief period
- The most famous short squeeze occurred in 2008 with Volkswagen
What is a short squeeze?
A short squeeze occurs when a lot of demand for an asset causes the price of the asset to skyrocket for a short period of time. This occurs when a lot of investors bet an asset price will go down but the price actually shoots up, causing all the short sellers (people betting against the asset) to buy back the stock to prevent them from losing more money. The sudden surge of people buying the asset causes a short squeeze to occur, a short period of extremely inflated prices.
An important metric to consider when discussing short squeezes is the short interest ratio. This is the number of days it takes for short sellers (people betting against the stock) to cover their positions (repurchase their borrowed shares). It’s calculated by dividing the number of shares trading short by the average trading volume, over 30 days. This metric measures the number of shares that are short and have not been closed out yet. Usually, a position is closed out once the option is in the money. However, if the option is not the money, then an investor will continue to hold the option. Therefore, a stock with a high short interest ratio could imply a potential squeeze because if the price of the asset keeps rising, this will force short sellers to buy back the stock, raising the price of the asset even more, eventually squeezing to an extremely high number.
The most well-known short squeeze in financial history is probably the GameStop squeeze that peaked on January 27th 2021. When a large number of retail traders from a group called WallStreetBets saw how high the short interest ratio for GME was, they decided to buy a ton of shares and hold onto them. By doing this, this was increasing the price of the stock. This became a war between retail and institutional traders, and as more retail traders bought shares and held for dear life, the price continued to rise. On January 20th 2021, GME had reached $40 a share. Almost a week later, GME was trading at $400 a share. The constant purchase of shares by retail traders kept driving up the price of the stock, forcing short sellers (big institutional funds) to buy back shares at higher prices, sending the stock even higher. It is said that institutions like hedge funds and private banks lost upwards of billions of dollars just shorting GME stock. One London hedge fund, White Star Capital, lost so much money going short on GME that it shutdown after amounting losses in the double digits.
Another very famous short squeeze occurred in 2008 with Volkswagen stock. When short sellers realized that Porsche had bought a major stake in Volkswagen and there would not be enough shares for short sellers to cover their positions, panic occurred. This caused the asset price to rise as high as €999, making Volkswagen one of the largest companies in the world for a short period of time.
However, once peak asset prices are hit and people sell their shares, more shares become available for short sellers to purchase, causing the price of the asset to return close to its intrinsic value.