Short squeeze

When investors are bearish on a stock (in other words, they think the price will go down), they can “short” it. This is a way of profiting from a drop in the share price.

The investor borrows the stock from a large holder, in exchange for a small fee, with the agreement to return the stock at a later date. They then sell the stock. They now have the cash from the sale, but they owe the original holder the stock.

However, if they’re right about the price falling, all will be well, because the share price will fall, they will be able to buy back the stock at a lower price than they sold it for, and they can return it to the original holder while pocketing the difference as profit.  

As you can probably gather, “going short” is a lot riskier than buying shares in the belief that they will rise (“going long”). If you are “long” a stock and it goes down, you can always hold on to it (you don’t have to give it back to anyone), and even if it goes to zero, the most you can lose is 100%. 

However, if you are “short”, there is no theoretical limit on how high a stock can go. As a result, you can easily lose more than 100% of your initial exposure.

On top of that, a short is not a “buy and hold” position – your view on the stock has to come good in quite a short window of time, or else you will end up – in effect – racking up costs for “renting” the stock from someone else.    

So while shorting can be profitable, it also leaves a short-seller quite vulnerable to sudden shifts in sentiment. And where a lot of short sellers have targeted a stock, this can make for very volatile moves. 

Here’s why. Let’s say a large number of short sellers have targeted the same stock. Don’t forget – to do this, the short sellers have to borrow the stock from someone else.

The bigger the proportion of stock that is on loan, the smaller the “free float” becomes. In effect, supply of the stock becomes restricted. If you then suddenly have a spike in demand for the stock – say its results are better than expected, or one of the big players who has loaned the stock into the market suddenly demands it back – the price rise can then force some short sellers to “cover” their positions by buying back stock in the market.

This in turn can force the share price to rise even higher, and in a dramatic fashion. This self-perpetuating circle is known as a 'short squeeze'.

Famous examples of short squeezes include the frenzy around troubled US video game retailer GameStop in January 2021. GameStop had been heavily shorted because selling video games from physical shops is about as outdated as buying music on CDs.

However, a group of private investors on social media site Reddit, posting under the group r/wallstreetbets, were feeling more optimistic about GameStop’s potential as a turnaround stock, given the interest of a new activist investor. They also noticed the huge “short interest”, banded together, bought in, and kept buying in. The share price spiked and several hedge funds got burned.

An even more extreme example is that of Porsche and Volkswagen, which may well be the biggest short squeeze in history. Put simply, in late 2008, in the depths of the financial crisis, Volkswagen was being heavily targeted by short sellers who thought it would go bust.

However, they reckoned without Porsche, which already owned a big chunk of VW. It eventually became clear that the “free float” of VW shares was much smaller than the shorts had realised.

When Porsche then warned about this fact over the weekend, short sellers panicked, tried to get out of the stock, and the VW share price more than doubled in a single day, then went even higher the next day. Short sellers are thought to have lost an estimated €20bn in the debacle.