Your Money: The Gamestop Saga Part 2 – What on earth is a “short squeeze?”

The wild ride in Gamestop stock was caused by a market phenomenon known as a short squeeze. We explain here what the mechanics of a short squeeze look like.

In Part 1 of this series we explained the mechanics and risks of short-selling. Now we want to move on and cover the concept of a short squeeze. For this we have to remind ourselves of how markets work.

Markets are the ultimate example of supply and demand, as you may have learned in basic economics class long ago. If more people want to buy something than there are people who want to sell it, whether it’s a stock or a house or a hot new toy that all the kids want at Christmas, the price of that item will increase. Conversely, if more people want to get rid of something than new people who want to buy it, prices will drop. If the imbalance of supply and demand is great enough, prices can go way up or way down at dizzying speeds.

While we all intuitively understand this price behavior, we may forget that it applies to stocks, and in fact it is the sole determining factor in the price of a stock. Yes, there may be brilliant financial analysts on Wall Street who can tell you a thousand reasons why XYZ company is going to be a massive success and its stock should be much higher than its current price. They may even be correct. But that does not determine the price of the stock. The price of the stock is based on the supply and demand of traders in the market at any given moment. Of course, if people listen to the brilliant analysts and agree with them, they might run out to buy the stock. This buying pressure can indeed cause the stock to rise, but the brilliant analysts themselves do not make it happen.

This characteristic of the market creates an additional risk for you as a short-seller. If for any reason a lot of people decide they want or need to buy the stock that you have sold short, there can be tremendous buying pressure that causes the price to increase very far, very fast. Remember that if you’re short, the more the price increases the greater your “paper” loss can become, and you might get a margin call from your broker. If you can’t meet the margin call, or if you simply decide to give up the fight and get out of your position before you pile up even greater losses, you have to purchase those shares.

Think about that – the price has gone up because of buying pressure in the market, and as a result of that price increase you are now forced to buy, which creates even more buying pressure and can send the stock price even higher. Now think about if there are a lot of people just like you who sold the stock short and are being forced to buy shares to cover their positions, or at least are choosing to do so voluntarily because they want to limit their losses. This can create a massive amount of demand for the stock, which can push the price up even higher, and the pace of that rise can increase dramatically, putting even more pressure on the shorts who remain in their positions with ever-growing losses.

You can see where this self-fulfilling prophecy leads. The more people who have to cover their shorts, the more the price rises, and thus the more other short-sellers have to cover their shorts, which causes the price to rise even more. This can happen very quickly and very violently, causing the stock price to rise in a way that seems almost unnatural. It’s literally a panicked frenzy of people trying to buy the stock, but because there’s not enough to go around, the price does nothing but continue to increase, causing the losses to pile up higher and higher. Meanwhile, the people who own the stock are seeing their profits skyrocket while they sit back and just watch.

This is called a short squeeze.

There is always a greater risk of a short squeeze in stocks that have a lot of shares sold short. And typically stocks of companies that genuinely appear to have dim future business prospects attract a lot of short-sellers, so they do have a very large number of shares sold short. i.e., the so-called “short interest” is very high.

Another related metric, which you see highlighted on the chart above, is "days to cover," which measures the numbers of shares sold short relative to the average daily volume of shares traded in the stock. It effectively measures how many days of average trading activity would be required for the collective short position in the stock to be unwound if EVERY trade were a short-seller covering his position. The higher the days to cover, the harder it will be for shorts to get out if they need to, meaning there is a better chance of a short squeeze.

If for any reason – legitimate or not – the price of such a stock should begin to increase considerably, there could be a lot of buying by short-sellers to cover their positions, which can trigger the increase in frenzied buying that we just described above: the short squeeze.

In the third and final edition of this 3-part series on Gamestop, we will explain how the GME stock was turned into one of the most extreme short squeezes in history. We’ll also explain why and by whom that short squeeze came about. Here’s a hint: it wasn’t kicked off by random fluctuations in the market.