A short squeeze (not to be confused with a “quick hug”) is an investing phenomenon that happens when the price of a stock that everyone seems to be betting against suddenly shoots up faster than a bottle rocket on the 4th of July.
From GameStop to AMC, short squeezes can potentially turn Wall Street upside down and capture the imaginations of many investors. Netflix is even planning to make a movie about the GameStop stocks saga (which we’ll talk about a little later).1
But how exactly do short squeezes work? And is there a way to spot one before it actually happens? Let’s take a closer look.
Understanding a Short Squeeze
Before we dive deeper into short squeezes, we need to talk about short selling (that’s where the “short” in short squeeze comes from). Here’s a quick refresher on short selling: When someone “shorts” a stock, that means they’re betting against it. Basically, they make money when the price of that stock goes down, but lose money if the price goes up.
In a nutshell, here’s how short selling works:
- First, you need to borrow the shares of a stock you want to bet against from a broker. Then, you sell those shares on the stock market. The catch is that you have to buy those shares back eventually and return them to the broker.
- If everything goes according to plan, the price of the stock tumbles down and you buy those shares back at a cheaper price than what you sold them for. When you return the stock to the broker, you get to keep the difference of the purchase as a profit (minus fees and interest).
- Problem: If the stock price goes up instead of down, you’ll lose money because you’ll have to buy it back for more than you sold it for.
For example, let’s say you want to “short” a stock and sell it when it’s worth $100. If the price drops to $75 a few weeks later and you decide to buy back that stock at that price, you would make a $25 profit. But what if the price soared to $150 instead? Then you would end up with a $50 loss.
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The bottom line is: Short selling is extremely risky—riskier than walking through a den of sleeping lions with your pockets full of beef jerky. You’re not really investing, you’re gambling. If you’re right, you can make some money. But if you’re wrong . . . you could be facing some devastating losses. Shorting a stock just isn’t worth the risk.
And that brings us to . . . the short squeeze.
What Is a Short Squeeze?
A short squeeze happens when the price of a heavily shorted stock unexpectedly shoots up in price. Basically, a short squeeze is when short selling backfires.
Some short squeezes last for a few days, and others could last for several months. Either way, it could cause some serious headaches for anyone short selling that stock.
What Causes a Short Squeeze to Happen?
When there are a lot of investors shorting the same stock, there’s a chance that many of them will end up buying that stock back at the same time. That causes a sudden surge in demand that drives up the stock’s price dramatically.
A short squeeze can feel a lot like playing the stock market’s twisted version of musical chairs. When the price starts to shoot up, the music stops and short sellers rush to buy back their stocks as quick as possible before the price goes too high.
There’s a lot of pressure on short sellers, and most of the time they don’t have the liberty of waiting to see if the price of the stock will go back down. Their brokers can demand their shares back at any time, they’re still paying interest on the shares they borrowed, and complicated margin rules mean they need to have lots of available cash to cover the losses they’re taking.
If a short seller doesn’t have enough cash in their account as their losses pile up, sometimes they will have no choice but to sell—no matter how huge their losses. Game over.
Real-Life Example of a Short Squeeze
One of the most dramatic short squeezes in recent memory started in January 2021 with GameStop, a brick-and-mortar chain of video game stores.
Here’s what happened. For years, GameStop was struggling to keep up with its competition and adapt to changes in the video game industry. COVID-19 didn’t help matters either.2 Many hedge fund investors on Wall Street thought GameStop was on its way to becoming the next Blockbuster and started shorting (aka betting against) the company’s stock.
A large group of online retail investors on the social media site Reddit noticed and saw an opportunity to hit these hedge funds where it hurts the most—their investment accounts. They banded together to buy a bunch of GameStop stock (say that 10 times fast) in order to drive up the price . . . and it worked! This army of Reddit investors triggered one of the most dramatic short squeezes in recent memory.
Watching GameStop’s stock price soar basically overnight, the short sellers who bet against GameStop were forced to buy back their stocks too, which drove the price even higher.
Just how high did GameStop’s stock go? It skyrocketed from about $17 per share at the beginning of January to a peak of . . . (are you sitting down?) $483 per share on the morning of Jan. 28. That’s nearly 30 times higher than it was at the beginning of the year.3
And while the price of GameStop’s stock went through a series of ups and downs in the following months, its stock price was still above $200 per share at the beginning of July 2021.4
When the dust settled, some hedge funds wound up losing billions of dollars after the short squeeze, and one London-based hedge fund announced that it was shutting down just months after facing heavy losses from betting against GameStop.5
Why Investing Based on Short Squeezes Is a Bad Idea
Some active stock traders (especially day traders) like to keep a close eye on stocks that are being heavily shorted. If they see the price starting to rise, possibly signaling the start of a short squeeze, they might try to jump in quickly and see how high the price of that stock goes.
But just because everyone is betting against a stock doesn’t mean a short squeeze is guaranteed to happen—far from it. For every GameStop or other stock that experiences a headline-grabbing short squeeze, there are dozens of other heavily shorted stocks that never experience one. Instead, they keep falling and falling in price . . . there is a reason why people are betting against these stocks, after all.
And because short squeezes usually happen all of a sudden, they can be very difficult to predict—you just never know when a short squeeze might start and end. And if you’re not careful, you can end up on the wrong side of a short squeeze.
An Investing Strategy That Works
Investing is a marathon, not a sprint—that’s why you need to have a long-term mindset when it comes to investing. Don’t get caught up betting for or against single stocks. Instead, focus on building a diversified portfolio that will help you build wealth slowly over time. Remember the story about the tortoise and the hare? Spoiler alert: The tortoise wins every time!
Here’s a simple, tried-and-true strategy for building wealth that has helped millions of Americans become millionaires over time:
1. Invest 15% of your gross income toward retirement.
According to our National Study of Millionaires, 3 out of 4 millionaires said that consistently investing over a long period of time was a key to their financial success.
Investing 15% of your income each month sets you on the path toward retirement security and leaves you with enough wiggle room to achieve other important financial goals, like saving for your kids’ college fund or paying off your house early.
2. Invest in tax-advantaged retirement accounts.
Outside of your 401(k), a Roth IRA allows you to enjoy tax-free growth and tax-free withdrawals on your investments in retirement.
3. Spread your investments with mutual funds.
Despite all the myths out there, the vast majority of millionaires didn’t hit it betting on (or against) a single stock. In fact, not a single millionaire listed single stocks as a big factor in building their wealth.7
Mutual funds, which contain dozens and dozens of stocks in them, help you invest in the stock market while reducing your risk through diversification. We recommend diversifying even further by spreading your investments across four types of mutual funds: growth, growth and income, aggressive growth, and international.
Work With a Financial Advisor
When it comes to investing, a few wrong moves can wreck your entire portfolio. One way to make sure that you’re making wise decisions that will help you build wealth over the long haul is to work with a qualified financial advisor you can trust.
That’s where SmartVestor comes in! With SmartVestor, you can connect with a financial advisor who can guide you and help you create an investment strategy that’s built to last.
Ready to get started? Find your SmartVestor Pro today!