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Ask Alex: What is a Short Squeeze?

This weeks question comes from Christopher Lee: “Can you explain what a short squeeze is?”

The quick explanation of a short squeeze:

Short squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and excess demand for the stock. It occurs when a stock is heavily shorted (a lot of people are betting that the stock should go down in price) and the stock moves sharply higher forcing short sellers to buy back shares to cover their positions, which in turn pushes the price even higher.

What is shorting?

An investor shorts a stock by “borrowing” it on margin through his/her brokerage account.The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. For this example, let's say 10 shares of Apple ($AAPL) at a price of $543 per share. At the same time as the borrowing happens, the shares are sold and the investor gets the proceeds of $5,430, but has to pay the margin interest. If the price goes down to $200 per share, the investor can buy 10 shares of Apple ($AAPL) in the market for $2,000 and give them back to the brokerage firm. Left is the $3,430 profit minus the margin interest. On the other hand, if the stock goes up to $1,000 per share you will get a margin call from the brokerage firm telling you to put in the additional $4,570 in your account (To make up the difference to the $10,000). Here is where a lot of people cover their position by buying back the shares instead of putting in the additional funds as they are afraid of losing more money.

What is short ratio and how do I see a short squeeze coming?

The short ratio or short interest ratio is a metric showing investors' sentiment. The ratio is calculated by dividing the number of shares sold short by the average daily trading volume (number of shares traded per day), generally over the last 30 trading days. The ratio shows the number of days it takes short sellers on average to repurchase all the borrowed shares. The ratio is used by traders to identify if there might be a short squeeze on the way. The higher the short ratio the bigger the chance of a short squeeze. I also like to look at the short percent of the float as the short interest ratio can change when the volume slows down. It is calculated by dividing the number of shares sold short by the total float (the shares available in the public market).

Real life examples of the short squeeze

A good number to know is 3.4%, that’s the average short interest across the S&P 500. Anything around there is not in any danger of a short squeeze. 2008 when a short squeeze temporarily drove the shares of Volkswagen on the Xetra DAX from €210.85 to over €1000 in less than two days, briefly making it the most valuable company in the world. The higher the short ratio, the higher the potential profits when the shorts get squeezed. (See “ASK ALEX: INVESTING FOR GAMERS – THE PERFECT STORM” for more examples of real life examples of a short squeeze).

So why would you want to short?

As you see there is a lot of risk involved in shorting as you can lose more than 100% of your initial investment. Despite this risk, historically, buying the most hated and heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28% each and every year. That’s some material outperformance during a decade when decent returns were very hard to come byThat's some material outperformance during a decade when decent returns were very hard to come by. Chris, I hope this answers your question! If you have any questions for me, please send them over to Ask Alex and maybe you'll be featured in next week's edition.
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Alexander Wallin is an experienced investor and Fintech expert. He has a passion for startups and making the financial markets more accessible to retail investors. Be sure to follow him on SprinkleBit!

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