Trading the financial markets is a specialist subject full of jargon and technical terms, which can often be confusing to those who are new to the markets.
One such phrase is “short squeeze” a common enough term that’s frequently bandied about by traders and the media, but not one that immediately explains itself to a novice or newbie trader.
“Short Squeeze” refers to a rising price driven higher, by an underlying short position in the market.
Short selling
Going short or shorting is the process of selling a stock, or any other instrument, that you don't already own. In the expectation of being able to buy that asset back at a lower price at some future point in time.
Imagine we decide to sell 100 shares of US retailer Walmart (WMT), as a CFD, for $160.00 each, because we were concerned about the health of the US consumer, in the face of “higher for longer” interest rates and persistent inflation.
Source: Barchart.com
All the time that the Walmart price is above our entry (sale) level of $160.00 per share, our short sale is losing money.
However, once the stock price moves and stays below $160.00, we are making money and the farther the Walmart stock price moves below our entry-level, then the bigger that profit will be.
In this example let’s imagine that we’re able to buy back our hundred-share short position in Walmart at $153.00 per share, which generates a profit of $7.0 per share
Profit = (entry-level - closing level ) * number of shares.
We never owned any Walmart shares - we simply speculated that the stock price could fall and traded accordingly. Our risk was that we were wrong and that the stock price would rise against us.
Stock Borrowing
When traders short a stock, either by selling physical shares or via a CFD, the underlying trade in the stock needs to be settled.
That is, the stock needs to be delivered to the buyer, and the sale proceeds/cash to the seller. In the case of a CFD trade, your broker/CFD provider assumes the role of the seller.
Your broker or their agent now needs to find that stock to settle the trade, and to do that they will need to borrow the stock.
Large long-term shareholders such as pension funds and insurance companies lend some of their stock holdings into the market for a fee, or interest payment, on the value of the stock being loaned out.
Stock loan fees are charged daily, typically at a known percentage above an interest rate benchmark, for example, SOFR +/- 1.00%, and the fees are charged on the full value of the stock being lent.
The fees on our imaginary trade in 100 shares of Walmart will be relatively modest, but they can soon mount up if we are talking about stock loans of 100,000 or even 1.0 million shares in Walmart.
The ability to borrow stock and other assets in this way supports short-selling and allows market makers and others to provide short-term liquidity and the two-way bid-offer prices, that are essential for ease of trading in the markets.
Short and caught
However, the stock loan system is not infallible and it’s subject to the same laws of supply and demand as the rest of the market.
There is generally a finite amount of stock that can be borrowed in a given issue, and though institutions are generally the largest shareholders in listed companies, they may choose not to lend their stock holdings, or be prevented from doing so by regulations or governance requirements.
Some stocks are closely held with the founders and venture capital backers retaining significant stakes in these companies, restricting what’s known as the free float in the stock. Which is effectively the number of shares in a company that are easily tradable.
When the demand for a stock outstrips its supply then prices can get “squeezed” and sometimes squeezed hard. For example, as here, (see the chart below) following the recent listing of Vietnamese EV maker Vinfast Auto (VFS). This wasn't a “short squeeze” per se but it was a price rise that was created by a severe shortage tradable of stock, in a climate of excess demand for the name.
Source: Barchart.com
History tells us that we ignore the power of a short squeeze at our peril. In 2008 a short squeeze developed, in the face of stakebuilding, in the German Automaker Volkswagen, by local rival Porsche. The squeeze became evermore severe and we saw the VW stock price rise almost 500% in two days. Such was the scale of the squeeze, that VW briefly became the largest company in the world.
Source: Investors Intelligence
In the second part of what is a short squeeze? We will take a look at how we can find stocks that could be vulnerable to them, and how we might be able to trade them using that knowledge.
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