How to Recognize a Short Squeeze in the Market

Let’s illustrate with an example.

Imagine you’ve taken a short position on a stock, expecting its price to fall. Let’s say it’s a stock of a company that has been showing poor results and the latest news reports are also expected to be negative. A trader then makes a decision to short this stock – borrow shares of the stock from a broker to sell at the current price, to then later buy them back at a lower price and pocket the difference.

But then, there is a twist. Against the trader’s expectations, the stock starts to rise. Soon, other traders also start noticing that the price keeps rising steadily, so they start to buy shares, hoping to profit from the trend. Shorts are now starting to pile up.

Now, there is a problem: short sellers begin to panic. The higher the price climbs, the more they realize they risk losing more than they initially invested. At this point, they start buying back shares to limit their losses. And that’s where it gets interesting: this buying creates even more demand, which causes the price to rise further.

This is when short-squeeze comes in — a perfect storm, where short sellers are forced to buy back shares, driving the price even higher, often beyond expectations. Those who shorted the stock are left with losses, while those who predicted the squeeze enjoy the profits.

Indicators of a short squeeze

Short squeezes often occur quickly and unpredictably. However, there are signs that can help you identify them:

A sudden rise in the number of shares bought could indicate a potential squeeze. This suggests that demand is growing and may trigger a squeeze.

A stock with increased volatility and sudden price movements may indicate that short sellers are scrambling to cover their positions.

High short interest (above 20%) refers to the percentage of a company's total shares that are being held by short sellers. A high percentage of short positions means that a large number of all outstanding shares are being sold short. The higher the percentage, the more likely a short squeeze is to occur.

Relative strength index (RSI) (below 30). RSI indicates overbought or oversold conditions in the market on a scale of 0 to 100. A stock with a low RSI means it is oversold, trading at a very low price; and a high RSI means the stock is extremely overbought, trading at a high price. Any RSI below 30 signals an imminent price increase, which could lead to a short squeeze. A company's online listing will usually include its RSI, often in the indicators section.

How to protect yourself from a short squeeze

As mentioned earlier, a short squeeze can lead to significant financial losses, but there are ways to mitigate excessive losses using two simple strategies:

Famous examples of short squeezes

Some of you might remember the heated discussions that took place in January 2021 about users on Reddit coordinating their actions to trigger a surge in GameStop stock. As a result, major hedge funds faced significant losses. Yet, this wasn’t the first time – other companies have experienced short squeezes before. Below, we list the most interesting cases.

Piggly Wiggly:

About 100 years ago, entrepreneur Clarence Saunders went to New York with $10 million in borrowed funds in an attempt to stand up against the stock market cartel. Saunders was an owner of the Piggly Wiggly supermarket chain, and business had been going well until the cartel started spreading rumors and betting against the company’s stock.

He tried to suspend trading of the company’s shares, and the price rapidly rose to $124. However, the stock exchange intervened, halting trading and giving short sellers time to find the necessary shares. This led to Saunders' bankruptcy and departure from the business. Many sympathized with him, seeing the rule change as unfair — a situation similar to what happened with Reddit users and Robinhood.

Volkswagen:

One of the most notable short squeezes occurred with Volkswagen in October 2008. Facing the imminent global financial crisis, hedge funds experienced significant losses due to short selling of Volkswagen’s stock, which skyrocketed from €348 to nearly €1000, making Volkswagen the most valuable company in the world for a short period.

The short squeeze started back in 1931 when Porsche began buying Volkswagen. Hedge funds saw an arbitrage opportunity, believing Porsche wouldn't buy up VW's common stock. But then Porsche unexpectedly announced that it had fully acquired the company, and only 6% of the shares were left in circulation.

Short selling of VW shares rose to 12% of the total, making it impossible for short sellers to close their positions. Panic spread through the market. On Monday, some traders managed to cover their positions, but those who waited until Tuesday saw VW's stock soar to a record $1207. Hedge funds lost around $30 billion. In the end, despite Porsche’s attempts to unload its positions, Volkswagen took over the company.

Summary

A short squeeze is a powerful market event that can lead to rapid and significant price increases in stocks with high short interest. Traders should be aware of its signs such as high short interest, rising prices, and increased volatility. Short squeezes can be very profitable, as well as risky, that’s why they are most suited for experienced traders who understand the potential for both massive gains and losses.