What is a Short Squeeze? Definition and Meaning

A short squeeze by definition is a sudden rise in the price of the stock, which results in many short sellers closing their position, effectively pushing the price of the stock up even further. When traders or investors short a stock, they ‘borrow’ the shares and then sell them, with an agreement in place to replace them at a future date.

As a short seller, your forecast for the stock is bearish. In other words, you predict that the price of the stock will fall at a point in the future.

This makes it possible to buy the shares back cheaper, with the difference between the buying price and the selling price being the profit. However, an important phenomenon occurs if the price of the stock suddenly starts to rise [goes against expectations]. Short sellers may then buy the stock en masse, before their losses increase sharply. Whenever a financial instrument is faced with excess demand, price reacts accordingly. Prices rise.

Example of a Short Squeeze with a Faux Stock

An example helps to clarify exactly how a short squeeze might take place. Consider a biopharmaceutical company named XYZ producing a vaccine for a virus. At inception, there may be tremendous interest in purchasing the stock, but if the company announces a delay in the roll-out of the vaccine, short sellers may jump on the bandwagon and drive down the price of the stock.

Short sellers expect stock price to decline

Fear that the company is facing pitfalls, loss of funding, or an ineffectual vaccine would warrant put options on the stock. However, if the vaccine rolls out and is faced with massive demand then those short sellers are in trouble.

Short sellers buy stock back

What can they do? Faced with the prospect of a rising stock price which would magnify losses for short sellers, they have to act decisively. Fearing continuing price rises, short sellers cashout by buying the stock back to prevent further increases in the price of the stock which would increase their losses.

This surge in buying activity among short sellers invariably raises the price of the stock over the short-term, causing a spike. As with all speculative activity, the fundamental value of the stock may not be worth the rapidly increasing price that is reflected on the markets.

Short sellers’ actions push up the price

Put differently, the actions of short sellers artificially inflate the price because they are scared of the impact a rapidly rising price in the stock will have on their short positions. By cashing out, they’re effectively cutting their losses before the price rises even higher. There are groups of traders and investors known as ‘contrarian investors’ who go long on stocks which are subject to a short squeeze.

Their futures contracts are bullish in nature. It is generally regarded as a high-risk option to go long on a stock that many have shorted. However, many traders feel that bullish propositions are better than bearish propositions.

Did the Dow Jones experience a Short Squeeze after the March 2020 Sell-Off?

The novel coronavirus had a devastating impact on the financial markets between March and April 2020. As the chart above reflects, the Dow plunged from record highs beneath 19,000, but rapidly rebounded. On April 14, 2020, MarketWatch writer, Nigam Arora inked an op-ed, ‘The Force that’s Propelled the Stock-Market Rally will exhaust itself this Week’. According to the data, the S&P 500 index, like the Dow Jones Industrial Average, rose sharply in the weeks following the unprecedented declines.

Short squeeze drove most of the recovery

The data later revealed that the majority of the recovery was directly attributed to the short squeeze phenomenon. This occurs when short sellers are forced to buy to cover short positions. After the short sellers acted, all other market participants felt compelled to cash in on the rising prices by buying stocks as well.

This momentum generated by speculative sentiment forces all prices to rise. Naturally, there is a fear of missing out, abbreviated by the acronym FOMO, which causes excess demand and rising prices.

Market eventually returns to equilibrium

It should be pointed out that a short squeeze is a short-term phenomenon. It cannot last indefinitely, and will ultimately burn bright, then fizzle out. A reversion to mean occurs in all cases as volatility subsides; that’s what returns the market to equilibrium.