What Is a Short Squeeze?
As I sit here writing this article, the headlines are heating up about the stock of a company called GameStop (GME). The company was subject to a massive short squeeze, which I will explain that terminology in a moment. To add insult to injury, the trading platform Robinhood, restricted access to accounts during this squeeze, which many are crying foul play.
Before describing a short squeeze, let us first describe what is meant by shorting a stock. Most investors purchase stocks with the hope that the price of the stock will increase sometime in the future. With short selling, it is the opposite. Investors hope the price of the stocks they short go down.
In essence, these investors are selling something they don’t own, i.e., the number of the shares shorted. They ask their brokers for permission to borrow a certain number of shares to be sold at a certain price. Then, if the price for the stock drops, they buy the shares back (which get returned to the broker) and the difference is their profit.
Brokers cannot give permission unless they find investors willing to lend out shares. Therefore, not all stocks are eligible for short selling.
Short Squeeze
Short selling does not always work out the way short sellers intend. If the price rises above the price they shorted, at some point they will have to buy the shares back at a higher price, resulting in a loss. When many investors are short a stock, a squeeze can happen when groups of investors (usually institutions) buy large blocks to cause the squeeze. This usually sets off panic buying on the part of the shorts. This panic buying exacerbates the problem because it causes the price to surge even higher.
Theoretically, short sellers can be on the hook for unlimited losses, as the price of a stock can go higher indefinitely. Therefore, anyone looking to implement short selling as part of an investment strategy should take that into consideration. Normally, though, brokers who lent the shares out will require the sellers to buy back the shares. But no one can guarantee the price they’ll be bought back.
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How to Profit on Falling Stock Prices
Many people believe that short selling stocks is not patriotic. Others believe that if a company is mismanaged, the stock of the company deserves to be punished. Stocks that are candidates for shorting are often ones where the underlying companies have not performed well.
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It is a philosophical debate and something you’ll have to decide for yourself. This article is not intended to take a position and is meant to describe market tools and how they work.
If you are not concerned with shorting as being unpatriotic but are concerned with the risks associated with shorting, you still can participate in profiting from falling stock prices. Buying put options on a stock is often a great way to profit should the stock price drop. Puts usually don’t have the stigma associated with short selling, too.
Resources
Dure, Elana. “Robinhood, Interactive Brokers Latest to Restrict Trading of GameStop and Others.” Investopedia, Investopedia, 28 Jan. 2021, www.investopedia.com/robinhood-latest-broker-to-restrict-trading-of-gamestop-and-others-5100879.
“Short Squeeze - Overview, How It Works, and How to Spot It.” Corporate Finance Institute, 23 Sept. 2020, corporatefinanceinstitute.com/resources/knowledge/trading-investing/short-squeeze/.
