What Is a Short Squeeze?

There has been a lot of talk in the news recently of an investing concept known as a short squeeze. Let's take a look at what it is, how it works and the risks associated with it.

When you hear the term short squeeze, it basically means squeezing the short sellers. A short squeeze can only happen when a security has been sold short, which is when investors borrow shares from a brokerage and sell them immediately, in the hopes of buying them back later a lower price (called short covering). If the short is successful, the shares are purchased at that lower price, returned to the brokerage, and the investor keeps the difference in price (minus costs, of course). If the short is unsuccessful (the price of the stock is going the other way), the investor must buy the shares a higher price and realize the loss, including any fees associated with the transaction. (Learn more in What is Short Selling and How Does it Work?)

The "squeeze" portion of a short squeeze occurs when the cost of a highly shorted security moves sharply upward. This sharp price increase can, of course, be caused by a multitude of factors, such the company announcing a new product launch, releasing a positive earnings report or being featured in a positive news story. Sometimes, however, a price jump can have no apparent company-related reason. For example, a highly shorted security could jump if a group of contrarian investors decide to buy it up. Whatever the cause, as the stock's price climbs, short sellers are forced to purchase shares back at a loss, which can drive the price of the security up further, in turn forcing other short sellers to buy back their shares at an even further loss. Ultimately, the short sellers are squeezed out of their positions.

Short selling is a high-risk investing strategy, because the factors that may influence the price of a security can be unpredictable. And while the potential gains of a short sell are limited, the potential losses are unlimited, because while the price of a security cannot fall lower than zero, it can, in theory, climb to any amount.

To know if any investing strategy is right for you, it's important to understand what your overall goal is for your money, how long you plan to keep your money invested and how much risk you're comfortable taking on. Check out the Investing Academy for more questions of the week, investing concepts and comprehensive guides.