The current Reddit-fueled short squeeze on stocks like GameStop (NYSE: GME) and AMC Theaters (NYSE: AMC) has more investors interested in shorting and how they can profit from a short squeeze. While participating in a short squeeze has the potential to generate a large amount of money very quickly, many investors aren’t aware that this option can also compound losses.

If you’re interested in learning more about the short squeeze phenomena, how you can predict short squeezes and the pros and cons of this type of investment, our beginner’s guide is an excellent place to begin.

What is a Short Squeeze?

Before we can describe how to make money on a short squeeze, we need to define short selling. Short selling occurs when investors bet against the price of a security or asset, believing that the price of the asset will decrease in the future. During a short, an investor will borrow a set number of shares of stock from someone on the market that currently owns them with the promise of returning the shares at a later date. Investors may short a stock on speculation, while hedge funds might use a short position as a form of insurance against a risky position held in the same asset.

The short seller will then sell the shares that they borrowed at the current market price. While the short is open, the short seller will pay interest to the lender who provided them with the shares. Ideally, the price of the stocks will fall and the short seller will be able to purchase them back for a reduced cost, return the shares, and keep the profit from the differences between the two prices paid, less interest.

A short squeeze occurs when a heavily shorted stock rises in value instead of falling. Say a company’s stock is expected to decline but instead receives a major piece of good news, the price of each share can skyrocket. In this situation, short-sellers are still required to close out of their position on their contract expiration date, despite the fact that they will be taking a loss when they buy back the shares they initially borrowed. This can put regular investors in an advantageous position, driving up the price of a stock to “squeeze” the short sellers, forcing them to buy in to cover their positions. This upward momentum compounds, pushing the price of the stock even higher. 

Be Aware of a Short Squeeze

Though a short squeeze can quickly cause the price of a stock to shortly rise in value, these changes in price are rarely driven by the underlying fundamentals of the company. Instead, investors use short squeezes as a quick play to earn a profit before exiting their positions once short sellers are squeezed out of their positions. 

If you do decide to participate in a short squeeze, understand which stocks are likely to see a squeeze and anticipate when the squeeze will occur so you can come out on top. Buying in when the price is too high can leave you with shares worth only a fraction of their original value after all short positions have been closed. 

Short Squeeze Pros and Cons

Participating in a short squeeze comes with both pros and cons. Let’s take a look at both the advantages and disadvantages of this investment strategy. 

Pros:

• Theoretically unlimited profits: The biggest draw of short squeezes is that short sellers are required to purchase back shares of stock they’ve shorted on the expiration date, no matter the price. This means that if a short squeeze does occur, there is no upper limit on the total profit that you as the investor can take away from the trade.
• Less risk for investors than short sellers: If you invest in a stock hoping for a short squeeze to occur and it doesn’t, the most you can lose is the amount of money that you invested. On the other hand, short sellers can undertake losses of more than 100% in addition to being subject to margin calls and interest. Anticipating a short squeeze is even less risky if you purchase long-term options, as you can simply choose not to execute the option if the stock doesn’t rise in value as you expected.

Cons:

• Can compound losses: While being on the right side of a short squeeze can result in a virtually unlimited profit, getting caught up in the hype of a squeeze can also leave you with losses. For example, during the current GameStop squeeze, the price of GME stock peaked at about $347 on January 27, 2021. Just 1 week later, on February 3, shares of GME traded at an average price of $92.41 per share.

While this isn’t a problem for investors who bought in when GameStop stock was trading at around $14 in October 2020, many investors got caught up in the flurry of activity and excitement around GME in January, buying in at prices of $300 or more. Those who are still holding their investments may be down hundreds or even thousands of dollars with little hope for recovery.

• May leave you with a fundamentally shaky stock: As we’ve stated, sharp increases in stock prices associated with short squeezes typically have little to do with the underlying fundamentals of the company they’re associated with. This means if you do miss the exit point on the short squeeze, continuing to hold the stock long term might not be a viable option. This can be especially true when you consider that heavily-shorted stocks are typically associated with companies that are failing financially.  

Anticipating a Short Squeeze

Timing a short squeeze can be challenging. Here are a few values you can use to predict when a short squeeze is coming.

• High short-interest percentage: The more investors or investment firms that short a particular stock, the more competition there will be to buy the stock back at an expiration date. As more investors short an asset, the interest paid on that asset rises as demand increases. More investors shorting a stock may make a squeeze more effective.
• High short-interest ratio: The short-interest ratio of a stock is calculated by dividing the stock’s current short interest by its average daily trading volume. The short interest ratio tells you, on average, how long it would take for a short seller to close out of their current position. The higher the short-interest ratio, the more likely a short squeeze is to occur, as competition to rebuy shares spikes. 

Best Online Brokers for Trading Short Squeeze

No matter if you’re planning on purchasing penny stocks, stocks for an upcoming short squeeze or long-term holds that you plan to keep in your portfolio for decades, the first step to investing is opening a brokerage account. If you don’t already have an active brokerage account, consider a few of our top choices below.  

Examples of a Short Squeeze

One major example of a short squeeze occurred in October 2008, when a short squeeze caused the price of car manufacturer Volkswagen AG to soar on the Frankfurt markets. After the public received unexpected news that fellow car manufacturer Porsche was planning to increase its shares in Volkswagen, a flurry of investors suddenly began buying into the stock. This caused the price of Volkswagen AG to move from a value of €210.85 to a value of more than €1,000 over the course of 2 days, as short sellers were forced to buy in at higher and higher prices to cover their shorted positions. This short squeeze briefly made Volkswagen the most valuable company in the world. 

During a short squeeze that began in October 2008, shares of Volkswagen stock quadrupled over the course of just a few days. This made it briefly the most valuable car manufacturer in the world. 

Of course, price fluxes from short squeezes never last forever. The price of Volkswagen dipped sharply after the conclusion of the squeeze. Today, Volkswagen’s shares are valued at about €132, or about $161 USD. 

Should You Get in on a Short Squeeze?

With the potential for limitless profits, getting involved in a short squeeze can be both exciting and profitable. It’s important to remember, however, that these squeezes can also be risky for both short position holders and sellers. If you do decide to get in on one of these riskier moves, remember to never invest more money than you can afford to lose. 

Frequently Asked Questions

Related content: How to Buy Volkswagen (VWAGY) Stock