- Part 1: What happened in the GameStop case and how are communities influencing stock prices?
- Part 2: Short selling – what is it?
- Part 3: Short squeeze – in simple terms
Hedge fund series: Short squeeze – in simple terms
Since the GameStop case came to light, the terms “shorting stocks” and “short squeezes” have now also become known to the general public rather than just to professional traders. This article describes when short squeezes occur and whether private investors need to deal with them.
In the second part of our hedge fund series “Short Selling – what is it?” you already learned about the short positions trading method.
As you now know, a trader can profit by speculating on falling market prices. The corresponding instrument (stocks) is only borrowed before being sold first and then bought again later when prices fall. This is called short selling. Other frequently used synonyms are “shorting” or “selling short”.
But what if the exact opposite of what you’re hoping for happens when you short a stock?
What is a short squeeze and how does it work?
We talk about a short squeeze when the supply of a large number of shorted stocks becomes scarce. This means that short sellers find that the price of the stocks does not fall as expected, but rises sharply. The higher the stock price rises, the more expensive it becomes for the short seller to buy it back. Since the stock is only borrowed, the seller has to buy it back in order to be able to return it to the lender. So they will try to buy the stock back as soon as possible in order to avoid greater losses.
But the more short sellers abandon their strategy and buy back the stock on the stock market, the more demand increases, driving up the price further. The more the price rises, the greater the short sellers’ losses. The “squeeze” is the pressure that the short seller is now under to abandon the strategy. This can be particularly problematic and expensive for short sellers if there are not enough stocks available to liquidate the position. If the price rises indefinitely, short sellers have to hope that companies will issue new stocks onto the market or that shareholders agree to sell stocks so that they can liquidate their positions. Theoretically, the risk is unlimited and the loss increases exponentially.
Not suitable for private investors
Time and again, we hear stock market success stories where a few small investors made spectacular sums in a very short time. Just as it is possible to achieve high profits, there is also a risk of extremely high losses – like with a short squeeze. The GameStop case is an example where hedge funds suffered billions in losses due to a short squeeze. Basically, shorting is a very risky trading strategy for making a lot of money. If, contrary to expectations, the share price rises, you will have to pay extremely high prices to buy back the stock.
You can find further helpful tips on investing in our article “Financial investment – how does it work? The comprehensive guide on how to get more from your money”.
This is the last part of our hedge fund series. Have you read the previous articles?