What is a short squeeze?
The term “short squeeze” refers to the pressure on short sellers to cover their positions as a result of sharp price increases or difficulty in borrowing the security the sellers are short, according to the definition of the US Securities and Exchange Commission.
A short sale is the sale of stocks you do not own. You typically borrow these stocks from your broker. Short sellers want to profit from an expected decrease in the stock price. If the price of the stock drops, short sellers can buy the stock back at a lower price and then return it to their broker. The difference in price is their profit. However, if the price goes up, short sellers lose money. The higher the price goes, the bigger the loss.
A sharp stock price increase usually triggers a rush by short sellers to cover their positions. This in turn drives the share price even higher, which can cause an even greater squeeze. You definitely don’t want to get caught on the wrong side of trades at this point.
A scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal, according to the SEC.
Case studies: GameStop, Volkswagen
GameStop, January 2021
- Subreddit forum WallStreetBets members noticed that institutional investors held huge short positions against troubled video game retailer GameStop
- Forum members, including lots of novice retail traders, started purchasing GameStop stock in large numbers
- GameStop stock rallied
- The New York Stock Exchange halted trading in GameStop shares several times
- Investors betting against the stock, including prominent Wall Street firms like Melvin Capital Management, were forced to close out their short positions by buying the stock
- This fueled a further rally in the stock price
- Robinhood and other brokers imposed temporary restrictions on GameStop trades
- Is this fraud? Market manipulation? We don’t know yet
- Is it illegal or not? The White House and the SEC say they are monitoring markets
- Is it a fundamental shift in investment? You bet!
Volkswagen, 2008
- In late 2008, Porsche started buying up shares of German carmaker Volkswagen to gain more voting rights
- The stock price rose without no apparent reason, the stock seemed overvalued
- Hedge funds began shorting Volkswagen stock
- Porsche revealed that it had gained control of 74% of Volkswagen voting shares
- With Lower Saxony's 20% stake, the shares available on the open market dropped to under 6%
- Half of the short sellers couldn’t close their positions
- The stock price skyrocketed, making Volkswagen the world's most valuable company for a day. That unforgettable day was October 28, 2008.
- Porsche today holds a 53.3% stake in Volkswagen
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