What is a Short Squeeze?
Short Squeeze Overview
A short squeeze refers to a significant increase in a stocks share price. This increase forces short sellers to close their short positions which in turn drives the stocks share price even higher.
Short sellers believe a stocks share price will go down. They borrow shares from another account, agreeing to replace the borrowed shares at a later date. If the stocks share price decreases, this allows them to buy and replace the borrowed shares at a lower price, profiting from the difference.
However, if the stocks share price increases this may force short sellers to buy the stock in order to limit their losses.
As the short sellers buy the stock, this flood of buy orders drives the stocks share price even higher.
Example of a Short Squeeze
XYZ Pharmaceuticals is a bio-pharma company with a promising new treatment for cancer. Initial trials were delayed due to FDA concerns. These concerns caused investors to question the efficacy of the new treatment, causing investors to short XYZ stock. However, once the FDA trials started, the initial results were promising. This caused the company’s share price to jump from $10/share to $20/share. Fearing the share price would continue to rise, many short sellers purchased the stock to close out their position and limit their losses. These additional purchases pushed the share price even higher to $25/share. If the short seller initially borrowed 100 shares of XYZ at $10/share and due to the short squeeze had to buy back the shares at $20/share the short seller would have lost $10/share or $1000.
-Happy Trading, Verdia