The term “short squeeze” is a phrase many investors and traders have likely heard of but might not fully understand. According to David Rojas, Founder and CEO of Blue Castle Ventures LTD, “people with Robin Hood are just people who were not working; they were trying to make a buck. They don’t know how short squeezes work. And they thought that thing could just go up.”

Essentially, a short squeeze is a phenomenon that occurs when investors who have shorted a stock are forced to buy shares to cover their position, leading to a surge in buying activity that drives up the price of the stock. In this article, we’ll explore the concept of short squeezes in more detail, including how they happen and how they can be identified.

What Is a Short Sale?

Before we dive into short squeezes, it’s essential to understand the concept of a short sale. A short sale is a trading strategy where an investor borrows shares of a stock from a broker and sells them in the market, hoping to profit from a decline in the stock’s price. The investor is essentially betting that the stock will fall in value, and they can buy back the shares at a lower price to return to the broker, pocketing the difference as profit.

For example, let’s say that an investor believes that shares of Company X are overvalued and likely to decline in price. The investor might borrow 100 shares of Company X from their broker and sell them in the market for $50 per share, generating $5,000 in cash. If the stock price falls to $40 per share, the investor could buy back the 100 shares for $4,000 and return them to the broker, keeping the $1,000 difference as profit. However, if the stock price rises to $60 per share, the investor would need to spend $6,000 to buy back the shares, resulting in a loss of $1,000.

What Is a Short Squeeze?

A short squeeze occurs when investors who have shorted a stock are forced to buy shares to cover their position. Short sellers typically have a specific time frame in which they must return the borrowed shares to the broker, and if the stock price starts to rise instead of fall, they may begin to feel pressure to close out their position before they lose too much money. If the stock price continues to increase, more short sellers may feel the same pressure, creating a feedback loop of buying activity that can increase the stock price.

One way to think of a short squeeze is a battle between short sellers and buyers. Short sellers are betting that the stock price will fall, while buyers are betting it will rise. If the buyers win the battle, the short sellers will be forced to buy shares to cover their position, which can drive the stock price up even further.

Identifying a Short Squeeze
Identifying a short squeeze can be challenging, as it requires a certain amount of market knowledge and intuition. However, a few signs investors can look for may indicate that a short squeeze is happening or about to happen.

One key indicator is a high short-interest ratio. This measures how many shares of stock have been sold short relative to the total number of outstanding shares. If the short-interest ratio is high, it may indicate that many investors are betting against the stock and could be vulnerable to a short squeeze if the stock price rises.

Another sign of a potential short squeeze is a sudden spike in buying activity or a surge in trading volume. This could indicate buyers are stepping in and pushing the stock price, putting pressure on short sellers to cover their positions.

Finally, investors can also look at the stock’s technical indicators, such as its moving averages and relative strength index (RSI). If these indicators suggest that the stock is oversold or undervalued, it could indicate that a short squeeze is likely to occur if the price starts to rise.

Conclusion

While short squeezes can be highly profitable for investors on the right side of the trade, they also carry significant risks. One critical risk is that short sellers can lose significant money if the stock price continues to rise. Short squeezes can also be volatile and unpredictable. Also, as David Rojas says, “mainstream media is all about a kind of propulsion of hurt.” So, don’t only bank on what the media says.

Despite the risks, short squeezes can be highly profitable for investors who can identify them and execute the trade effectively. In some cases, short squeezes can lead to massive gains in a short period, making them an attractive option for investors looking to make a quick profit. Short squeezes can also be a way to capitalize on market inefficiencies.