Every market has buyers and sellers, and the stock market is no exception. An investor buys a stock with the expectation that the company will do well and, in turn, its stock price will go up. But the opposite is also possible thanks to a trading method called short selling. And can even lead to a phenomenon called a short squeeze.

On the contrary, there are a group of investors who short sell a stock. In other words, they bet against a company’s stock. They are of the view that fundamentals are not in favour of the company. As a result, the company’s stock will go downward. When there is a high level of short-selling, it can push the price of a stock very low. And At this low level comes the potential for a short squeeze.

What is a short squeeze?

A short squeeze occurs in a financial market when a stock that has been heavily shorted begins to get sudden buying pressure which causes a rapid increase in the share price. This could be a result of some positive news or some form of catalyst or the other.

When short squeezes occur, many investors buy the stock, squeezing short-sellers out of their position. As short sellers begin to exit their short position, the price of the stock surges even more rapidly. This, in turn, causes some other short-sellers to buy back the stock to cover their loss, pushing the price even goes higher.

This is precisely what happened in January 2021 when GameStop Corp (NYSE:GME) and AMC Entertainment (NYSE:AMC), among other shares, experienced a short squeeze. The catalysts in this instance were a group of retail investors in a Reddit community called WallStreetBets. These retail investors ganged up to buy these businesses solely intending to drive up the price. This, in turn, triggered a bunch of margin calls for hedge funds with over-shorted positions, which only amplified the upward momentum.

At the end of the short squeeze, GameStop shares rose from less than $20 to $483 within a few days. And AMC Entertainment moved from less than $5 to $20.36. 

How to identify a short squeeze?

Just like the stock market, it’s difficult to predict or time a short squeeze. But some telltale signs may indicate the possibility of one for a particular stock.

•  Short Interest Percentage – A short squeeze is more likely to occur in stocks that are heavily shorted. When this happens, they may later compete to buy that stock after their short interest expires. This is calculated by dividing the number of shorted shares by the number of shares outstanding.
• High Short Interest Ratio – Short interest ratio gives information on how long it will take short sellers to close their short positions. Historically, stocks with a high short interest ratio have a higher possibility of being targeted for a short squeeze. The short-interest ratio is calculated by dividing the current short interest of a stock by the average daily trading volume of the stock.

Beware of the risks

The way to profit from a short squeeze is to anticipate it. An investor who bought the shares before the short squeeze occurs will have the lion’s share as they reap the benefits of buying at the best price.

However, this investing style is heavily dependent on speculation making it more suitable for day trading rather than long-term buy-and-hold investors. So, it should be no surprise that using this investment strategy comes with a significant amount of risk.

While the initial momentum can create a lot of excitement, it’s important to remember that the growth isn’t typically backed by any solid underlying fundamentals. And consequently, in most cases, as we’ve seen recently, the growth becomes unsustainable and eventually reverses.

Investors who participated in the 2021 short squeeze and held on too long know this all too well. After all, both GameStop and AMC Entertainment shares currently trade well below their peak levels.