The Short Squeeze
This term has been back in the headlines ever since shares in GameStop, a US retailer of video games and gaming merchandise, experienced a spectacular rise in prices at the start of 2021.
Equity markets are highly unpredictable. Sudden changes in share price movements, either upwards or downwards, are a common occurrence. While most of these shifts are prompted by some kind of underlying logic or news, they can often happen for no reason at all.
What is a short squeeze?
A short squeeze is a term used in the equity markets to indicate a sharp increase in the price of stocks with a high number of short sales. The existence of stock futures trading is a prerequisite for short sales. Until electronic trading was introduced on the SIX Swiss Exchange in 1995/1996, anyone in Switzerland could buy or sell shares on a specific date without physically owning them. After paying a premium over the spot rate for this opportunity, investors simply had to close the position within their chosen timeframe — usually one to three months. On the expiration date, investors were and still are either credited or charged the difference between the purchase price and the selling price. A short buyer or seller borrows the money required to enter into a futures transaction. However, they do not own the underlying security. While futures transactions help to increase market liquidity, they are at risk of suffering a short squeeze in extreme cases where an extremely high number of shares are sold short by one or more investors in a stock relative to the total maximum number of shares available. Although past short squeezes were usually caused by incorrect assumptions about how a stock will perform in the future, recent events have shown that they can also occur for no apparent reason. The end result is the same in both cases. Short sellers are sucked into a downward spiral in which they are forced to buy back their shares, thus contributing to both the share price rise and their own losses, while investors with long positions emerge as the winners in this situation.
Thanks to Swiss DOTS, it is possible to open both long and short positions on equities with products such as mini-futures, knock-out warrants, factor certificates e warrants.
Recent examples
The GameStop stock caused a stir at the start of the year. GameStop is a US retailer of video games and gaming merchandise whose shares closed below $20 per share on 12 January 2021. This was followed by a series of short squeezes over the next ten trading days that caused the share price to surge to more than 15 times its previous value, reaching a peak of $485 per share during trading on 28 January. Shares in cinema chain AMC Entertainment exhibited a similar trend when the price rose by around 300% on 27 January 2021 to close at $19.88.
New market developments
Although short squeezes have been around for some time, they were previously driven by professional investors. One of the most sensational examples was the explosion in Volkswagen’s share price in 2008 when several institutional investors sold the stock short and were forced to make sizeable covering purchases when the share price rose. The short squeeze at VW was partly caused by confusion among US investors who could not get their heads around the company’s shareholder structure or the fact that its stock was divided into ordinary and preference shares.
The most distinctive thing about the GameStop and AMC examples is that this time the key players were retail investors who deliberately pushed share prices higher.
At the same time, however, the shares in question were particularly well suited for this kind of campaign as they were associated with relatively small companies with a correspondingly restricted market. Short squeezes can happen in any market. There has also been recent evidence of this phenomenon on the SIX Swiss Exchange in stocks such as Dufry, Molecular, Wisekey, U-Blox, Santhera, Meyer Burger, Autoneum, Zur Rose and Basilea.
How can short squeezes be predicted?
If there is a sudden increase in the number of shares sold, this could be a warning that a short squeeze is imminent. The short interest, i.e. the number of shares sold short divided by the total number of shares outstanding, is another indicator to bear in mind. A high short interest means that more short sellers will be competing with one another to buy back the stock when its price rises, making it more likely that a short squeeze will develop.
Betting on a short squeeze
Contrarian investors may buy stocks with heavy short interest in order to exploit the potential for a short squeeze. Active traders will monitor stocks with a high short interest and watch for them to start rising. Experienced traders will only buy into a potential short squeeze when the share price begins to gather momentum.
Short squeezes generally happen in stocks with heavy short interest.
However, short sellers often have well-founded reasons to believe that share prices will fall, as they base their decisions on a close examination of the company in question. One good example of this is the case of Wirecard, where short sellers were expecting the share price to fall long before the company’s accounting fraud came to light.
Risks of trading short squeezes
There are many examples of stocks that moved higher after they had a heavy short interest. But there are also many heavily shorted stocks that then continue to fall in price. A heavy short interest means that many people believe the share price will fall. It does not mean the price will rise. Anyone who buys in hopes of a short squeeze must therefore have other, better reasons to think that the price will move higher. Short sellers should bear in mind the high borrowing costs associated with the shares. There is also a risk of runaway losses, as there is no limit to how high a stock’s price can rise, and the short seller is obliged to buy back their shares at some point.
How to identify a short squeeze
The short interest ratio provides useful information here. This key figure shows the ratio of all realised short sales in relation to the stock’s average daily turnover. This enables traders and investors to work out roughly how much time is left before short sellers must buy back their positions. However, any official figures for European stock exchanges are either delayed or not provided at all. Only the New York Stock Exchange provides good and timely information free of charge. For example, information on this subject can be found on the website www.highshortinterest.com.
The Swiss DOTS platform offers you access to a wide selection of leverage products with various underlying products, such as international and Swiss equities, currency pairs, indexes or even precious metals.
At the same time you can benefit from particularly long trading times — from 8:00 to 22:00 — and various order options.
Swiss DOTS products can be traded at a flat rate from just CHF 9.- .
DISCLAIMER
The content of this article (including market commentary, market data and observations) is not a work product of any research department of Swissquote or its affiliates. This material is intended to highlight market action and does not constitute investment, legal or tax advice.
Swissquote makes no representation or warranty as to the quality, completeness, accuracy, comprehensiveness or non-infringement of such content. The views expressed are those of the consultant and are provided for educational purposes only. Any information provided relating to a product or market should not be construed as recommending an investment strategy or transaction. Past performance is not a guarantee of future results.
Swissquote and its employees and representatives shall in no event be held liable for any damages or losses arising directly or indirectly from decisions made on the basis of the video content.
The use of any third-party brands or trademarks is for information only and does not imply endorsement by Swissquote, or that the trademark owner has authorised Swissquote to promote its products or services.
Swissquote is the marketing brand for the activities of Swissquote Bank Ltd (Switzerland) regulated by FINMA, Swissquote Bank Europe SA (Luxembourg) regulated by the CSSF, Swissquote Bank Ltd (UK) regulated by the FCA, Swissquote Financial Services (Malta) Ltd regulated by the Malta Financial Services Authority, Swissquote MEA Ltd. (UAE) regulated by the Dubai Financial Services Authority, Swissquote Pte Ltd (Singapore) regulated by the Monetary Authority of Singapore, Swissquote Asia Limited (Hong Kong) licensed by the Hong Kong Securities and Futures Commission (SFC).
Products and services of Swissquote are only intended for those permitted to receive them under local law.
All investments carry a degree of risk.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74–89 % of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Digital Assets are unregulated in most countries and consumer protection rules may not apply. As highly volatile speculative investments, Digital Assets are not suitable for investors without a high risk tolerance. Make sure you understand each Digital Asset before you trade.
