What it means
A short seller borrows shares and sells them, hoping to buy them back later at a lower price and keep the difference. If the price rises instead, the short seller loses money, and the more it rises, the bigger the loss.
At some point the short seller has to buy shares to close the position, either because the lender wants them back or because losses force a decision. This buying adds to demand and pushes the price up further, which forces more short sellers to buy, creating a spiral.
Short squeezes are most likely in shares with a small number of shares available to trade and a large number of shares sold short. Positive news, a surge of buying by individual investors or large purchases by a single investor can all trigger one.
Once it starts, it can feed on itself for days. The term is used in other ways too.
A margin squeeze means a business's profit margin shrinks because costs rise faster than prices, and a credit squeeze means banks cut lending so that borrowers find it hard to get loans. In each case, the common theme is pressure that leaves little room to manoeuvre.
For a short seller the pressure is the loss from a rising price, for a business it is the narrowing gap between costs and revenue, and for a borrower it is the shrinking supply of credit. For finance professionals, squeezes are a reminder of the risks of leverage, meaning the use of borrowed money.
A position that looks small at the start can become very large relative to the investor's capital once prices move sharply, particularly for short sellers, whose potential loss is theoretically unlimited.
In practice
Real-world examples.
Example
A hedge fund has sold short a small retailer's shares. A surprise takeover rumour pushes the price up 40% in a day, and the fund buys shares to limit its loss, adding to the rise.
Example
A manufacturer faces a margin squeeze when raw material costs rise 12% but its customers refuse to accept more than a 3% price increase. Profit margins fall and the finance team looks for cost savings.
Example
A small business finds that its bank has cut its overdraft limit during a credit squeeze. The owner must collect customer payments faster and delay some purchases to keep cash balanced.
Formula
Calculation
Loss on a short position = (buy-back price - original sale price) x number of shares
An investor sells short 10,000 shares at $20, receiving $200,000. A squeeze pushes the share price to $32, and she buys the shares back to close the position. Loss = (32 - 20) x 10,000 = 12 x 10,000 = $120,000, which is 60% of the original sale value. Had the price fallen to $15 instead, she would have gained (20 - 15) x 10,000 = $50,000.Case study
Seen in the real world.
Arden Home Goods is an illustrative, fictional listed retailer with a share price of $8. A group of investors believed the company was struggling and sold short 30% of its available shares.
When the company announced unexpectedly good quarterly sales, the share price jumped to $11 in a day. Short sellers began buying to close their positions, and by the end of the week the price had reached $16.
A fund that had sold short 100,000 shares at $8 lost (16 - 8) x 100,000 = $800,000 when it was forced to close. The illustrative lesson is that a short position has unlimited potential loss, and the fund adopted a rule to close any short if the price rose 25% above its sale level. At that rule, the fund's loss on the same trade would have been capped at about (10 - 8) x 100,000 = $200,000. Risk limits like this are a standard feature of professional short selling.
Watch out
Common mistakes.
- Assuming a short position can only lose what was invested, when losses can be many times larger if the price keeps rising.
- Joining a rapidly rising share price without recognising that the rise may be driven by forced buying rather than strong fundamentals.
- Using the word squeeze only for share prices, when it also describes pressure on margins and credit.
Questions
People also ask.
What causes a short squeeze?
It starts when the price rises against short sellers, and forced buying by those closing their positions pushes the price higher still.
Do squeezes last?
Usually not, since once the short sellers have closed their positions the buying pressure disappears and the price often falls back, sometimes sharply.
How can short sellers protect themselves?
They can limit the size of positions, use stop-loss orders to close automatically at set prices or buy options that cap the possible loss.
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