What Is A Short Squeeze?

When you think a stock is going up, you buy the stock so that you can sell it afterwards at a higher price. This can also be called taking a “Long” position. Likewise, when you think the stock is going down in value, you’d want to sell it now and buy it at a lower price as it is going down anyways. If you have that particular stock, that makes sense to sell it. But if you don’t, how would you sell it? Here comes the concept of Short Selling.

If the value of a stock, say X, is going down, you could ask your broker, who may have X in any of their other clients, to lend it to you. When he does, you could sell it. Thereafter, if it goes down, you could exit your short by buying it at that lower price and then return it to your lender i.e. broker. BUT if it goes higher than where you entered the position, then you may have to buy the stock back at the higher price to give it to your lender. The latter situation culminates in a Short Squeeze.

See, when in a short position, you have to pay a fees for borrowing, post collateral based on the value of the borrowed shares, and generally have to return the shares you borrowed if the lender asks for them back. If you go on shorting but the value of that stock keeps on rising, your lender may ask you to return it so that he can then sell it at the higher price and reap the gain. But you’d have to buy them at that higher price. So you may say that you’re “squeezed”!

Take a hedge fund ABC for example. Say ABC shorted the stock of Co. X but the stock went up and up. After certain point of time, ABC would have to return some of the stock and it would be forced to buy it at a higher price. We’re talking about a hedge fund here. The position taken may be for millions of shares. Think what may happen when they buy it at a higher price to cover their position – they’d essentially be buying lots of them, in turn further driving its demand and price. This forms like a feedback loop until you completely exit the short position – that too at a huge loss!

Shreesha S
Shreesha S

Shreesha is a Qualified Certified Management Accountant(CMA) and Certified in Strategy and Competitive Analysis(CSCA).

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