A short squeeze relates to a scenario where a traded stock or commodity which has been heavily shorted suddenly moves aggressively higher without advance warning. This creates a self-fulfilling prophecy in which the short sellers feel so painful a loss that they are forced to close out their shorted positions. They actually increase the upward momentum and pressure on the stock by doing so. Such short squeezes give the impression that short sellers have no choice but to abandon their own short positions at a significant loss typically.
These are often triggered by sudden positive news announcements or company developments which give the idea that a stock may be beginning a turnaround in its fortunes. It could be this is only a temporary effect, yet not many short sellers are able to afford to hold losses which are running away limitlessly on them. In these cases, they stop the proverbial bleeding by closing them out, even though this means booking the so- far only paper losses.
When the stock begins to rise astronomically and quickly, the trend becomes self- reinforcing many times as the short sellers all trip over each other in their stampede towards the proverbial exit doors. When stocks go up 15 percent in only a single trading session, the short sale holders will often have not choice but to sell out and cover these loss-making positions via buying back the stock. When sufficient quantities of short sellers all do this at once, the stock price rises even more.
There are two practical means of determining which stocks are at greatest risk of falling victim to a short squeeze. The tools are short interest and short interest ratio. With short interest, this refers to the aggregate shares which are short sold as a percentage of all outstanding shares. Short interest ratio proves to be the actual numbers of shares that are sold short divided using the average daily trading volume of the stock in question.
Considering a hypothetical example helps to understand this concept better. A biotech company Britex possesses a drug which is a participant in advanced FDA clinical trials for treating skin cancer. Investors may be highly skeptical about whether or not such a drug will really work effectively and without dangerous and unacceptable side effects. Because of their doubts, 10 million shares of the Britex stock out of their total 50 million shares may have been short sold. This means that the short interest on Britex stock proves to be 20 percent. As the daily trading volume averages approximately a million shares, the SIR would be five. This SIR conveys that it would require five trading days for the short sellers to be capable of purchasing back all of their shares which they have sold short.
It could be that the enormous short interest has caused the price of the stock to drop from $15 to around $5 per share in advance of the clinical trial results. If the results were successful as the announcement came out that it treated skin cancer effectively, Britex stock would gap massively up on the news results. It could rise to more than $8 because speculators will simply pour into the stock. Short sellers would then be desperate to cover their short positions as soon as possible. The short squeeze in Britex shares would then be on in full force. This could press the stock to significantly higher levels because of the rapid unwinding of the short positions.
Those investors who are contrarians seek out stocks that are overly shorted exactly because a serious risk of short squeeze exists. They can build up massive long positions in such heavily shorted securities when they determine that the odds of success are much greater than what the short interest implies. They are taking on a calculated risk and hoping for a tremendous risk to reward potential payoff when the stock is only trading for a few dollars per share. They assume risk only limited to the price of the long positions, since the stock can not drop below zero. The potential for profit is in theory limitless.