Curious what happened to GameStop’s price in January of 2021? Considering being a degenerate by joining WallStreetBets and wanted to learn more about what they mean by a ‘short squeeze’? Look no further: in this post, I’ll explain what a short squeeze is and run through a “hypothetical” example of how this phenomenon happens.

I’ll also provide some recommendation on what you should do with this information.

Quick Refresher: What Is Short-Selling?

You’ll need to know the mechanism behind short-selling to properly understand a short squeeze.

A quick refresher from my post on what short-selling is. “Shorting” a stock just means borrowing shares and selling it for money in the hopes that the shares will depreciate in value. Once the shares depreciate in value, short-sellers buy the shares back so they can return it back to their lenders, thereby securing a profit.

The converse is true: if the stock price goes up, short-sellers lose money.

Short-selling has the following risk profile:

• Maximum upside is you keep all the money in your short-sale (i.e. share price goes to $0).
• Maximum downside is infinite, as the share price can go to an arbitrarily high value. This is especially true in a short squeeze, which I’ll illustrate below.

What Is A Short Squeeze?

A short squeeze is a phenomenon that can happen when a heavily shorted stock rises in value.

A heavy price increase can cause short-sellers “panic buy” in order to cut their losses. This heavy buying volume causes the share price to soar even higher.

This in turn causes even more short-sellers to want to cut their losses (or they’ll get margin-called in which case the shares are forcibly bought back), which creates even more buying pressure.

This spiral creates a positive feedback loop, which causes the share prices to skyrocket is extremely irrational values.

Early long positions get rich, and short positions either get margin-called, have to cut their losses, or if they stay in, they’ll lose an unimaginable sum of money.

Example Walkthrough Of A Short Squeeze

Here’s an example of how a short squeeze could happen, in chronological order:

1. Company XYZ is a retail store that sells games with mediocore sales. COVID hits and the market thinks that $XYZ will not last much longer before bankruptcy.
2. As a result, a bunch of institutional investors and retail investors short the stock, as they anticipate share prices declining.
3. Note that it’s possible that the “short percent of float” (the percent of shares borrowed to sell short) can exceed 100%. This can because a single share can be borrowed multiple times by different people. Let’s just say for $XYZ the float is 200%, or the number of shares borrowed to short is twice as much as all the shares in existence.
4. At this time, $XYZ is at $5/share.
5. News comes in that a CEO with a nice e-commerce track record will be joining $XYZ’s board. The stock has renewed confidence as investors anticipate sales to skyrocket due to: 1) increased gaming demand due to COVID lockdown, and 2) $XYZ’s transition to e-commerce which will allow for a significantly more profitable business model.
6. $XYZ jumps to $8/share.
7. Retail short positions panic losing 60% of their money and start “buying to cover” their borrowed shares.
8. This influx of buys means that sellers can sell at whatever price they want. And of course, people will naturally want to sell their shares as high a price as possible. Thus, there’s not going to be a lot of cheap sell limit orders in the market. Any cheap sell limit orders will be eaten up by the influx of buying, which means only more and more expensive sell limit orders are available to be fulfilled.
9. This causes price to increase to $10/share.
10. At this point, almost all the retail investors are margin-called or buy back shares to protect their losses from exceeding 100%. This in turn causes the price to soar to $15/share.
11. Institutional investors have a lot of money and decide that they’ll just short the stock even more to ride out this short squeeze.
12. New retail short sellers come in at $20/share because the price is “frothy.”
13. The short squeeze continues to $40/share, and all the retail short sellers cover their massive losses, causing the shares to jump to $80/share.
14. This short squeezing continues as new shorters come in and commit financial suicide by jumping in front of a short squeeze locomotive.
15. Shares jump to $160/share. Notice at this point that a $50,000 short position at $5/share means a $1.6 million loss here. And this can happen within weeks.
16. The institutional investors have a lot more money and this is most definitely the end of the short squeeze, so they YOLO a bunch of money in to short the stock.
17. A large amount of retail investors jump in to buy the stock at frothy prices, as they’re well aware of how much they can profit if they squeeze institutional investors dry. Thus, they band together and buy a shit ton of shares with 0 intention of selling.
18. This causes the shares to skyrocket to $300+/share.
19. With extreme losses, institutional investors finally give up and start buying back a mind-boggling amount of shares to get out of their deep position.
20. The share price is now at $360/share and the short percent of float returns back to a relatively normal state. Retail long positions are happy with the gains and a lot of them sell their position.
21. The share price plummets due as retail investors selling to take profit, and an equilibrium between short and long action is reached. The short squeeze is over.

NOTE: Recall in the beginning of the example that the short percent of float is 200%. This means for there to be a healthy short percent of float (~5%), almost all existing shares needs to be bought back twice. This represents immense buying volume and just turning over those shares in a short amount of time can cause share price to explode upwards.

What You Should Do With This Information

Some investors will use short percent of float as a buying signal. If a stock is heavily shorted, traders might take a long (buying) position due to:

• Limited downside, unlimited upside (the opposite of the risk profile described above).
• Speculation that a short squeeze will happen some time in the future.

This investment strategy is speculative and I don’t recommend it. Most value traders will take short percent of float as only one of many variables in order to invest. Trading solely based on short interest and the potential of a short squeeze is absolutely asinine.

This is due to the risk that the stock might never squeeze at all and instead collapse for an extended period of time. In this case, you’d underperform the market in general lose a lot of money on opportunity cost.

What you should do with this information: nothing. Unless you hate money and like being called a degenerate, you shouldn’t try to trade individual stocks with any significant amount of money.

Instead, you should just buy a relatively safe, high return ETF, like the S&P 500.

PS: If you were going to try and play short squeeze (or worse, shorting a stock) and this post convinced you to *NOT* give yourself years of financial setback, please feel free to sing my praises by emailing me at hello@goodmoneygoodlife.com or leave a comment below. Or feel free to YOLO your life savings in your favorite stock of choice and let me know if you end up with a lambo or homeless!