The knock-on effect of surging prices in a specific stock or security is caused by a short squeeze. As the name suggests, this phenomenon occurs when there are a large number of traders shorting a stock. If traders are banking on the price to fall, but conversely the price starts to rise, a squeeze will set in where a number of these traders start to sell their positions in order to cut losses.
The Emergence of Short Squeezes
Traders take out short positions because they believe that the price of an underlying stock will decrease. However, due to a number of different factors, demand in the stock might be sparked. If this sudden turnaround continues forth, then short sellers face potential high losses; more so the closer to the expiration date of their short positions.
Many short sellers will choose to exit their positions – regardless of the current lose they face. Every time a short seller exits, it sends the price even higher, reinforcing the squeeze and leading to even more short sellers to purchase the stock at the higher price.
Understanding How Short Squeezes Work
As mentioned, stocks that have been shorted by a large number of investors will be sold off if the price suddenly increases without warning. This is done to curb losses, particularly if the stock is set to shed its price further.
The short sellers borrow underlying shares because they think the price will fall and can pay back the purchased stock at a lower price and in turn keep the difference in price paid and sold as profit. However, if the price increases instead of decreases, then the difference in price will require them to buy the stocks at a price which leads to a loss at the end of the day.
Buy orders are used by short sellers to exit their positions, and this in turn drives up the price of an underlying stock. Furthermore, due to the increase in the price of a stock, buyers are attracted to the market due to the trading opportunities inherent in the security at hand. This convergence of short sellers and potential buyers means the price of a security can skyrocket in no time at all.
The subsequent exodus of short sellers is referred to as a short squeeze as these individuals have no option but to exit their positions, mostly at a loss. Thus, they’re squeezed out.
Trying Your Luck on Short Squeezes
Certain investors, who look to make the most of short squeezes, are known as contrarians. Bear in mind that, although there is reward if a short squeeze is taken advantage of effectively, the risks involved are just as prevalent. Various securities are shorted because there is little hope in future growth.
It’s important to keep a close eye on shorted stocks. Traders will analyze shorted stocks, and if the price starts to move upwards, traders buy the stock, and then attempt to resell it at an even higher price as a short squeeze sets in.
What are the Risks of Short Squeezes?
At the end of day, there have been many occasions where the price of stocks have continued to climb higher due to short interests. However, the fact that stocks have short interest is because there is ample cause to believe that the price will actually drop – and in many instances – this happens.
It’s vital to have good reason when buying a security so as to take advantage of a short squeeze simply than hoping the price will continue to rise.
Naked Short Selling
There is a practice of short selling stock which individuals haven’t actually borrowed. Furthermore, while doing so, the fact remains that individuals are selling stocks while it’s unclear as to whether the underlying asset actually exists. This practice is illegal and the Securities and Exchange Commission (SEC) in the US has clamped down on those engaging in naked short selling activities.(1)U.S. Securities and Exchange Commission.“Key Points About Regulation SHO.”
The fact that there is a lot of potential reward, albeit similar risk, means that people still utilize naked short selling tactics. Moreover, differences that reside between paper trading and electronic trading enable naked short selling activities to still take place.
It has also been noted that naked short selling, with the increased short selling during a squeeze, will help the market find equilibrium. This is due to to naked short selling leading to a price decrease, thus forcing certain sellers to sell off assets, and thus leading to a balanced market once again.
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