Fool on the Hill
A Short Course on Short Squeezes
Individual investors often think of a "short squeeze" as something like a summer romance -- intense, pleasurable, and a perfect elixir for what ails them. But what is a short squeeze really, and is it something you can enjoy without morning-after regrets?
Short-sellers typically make their money by betting that stock prices will fall. They do this by "shorting" a stock rather than "going long." That is, instead of buying a stock with the intention of selling it later at a higher price, the "short" sells first with the intention of buying the stock back later (or "covering") at a lower price. The short pulls off this perverse-sounding feat by initially selling stock that's been borrowed from someone else. Who would loan them stock? Well, you would. If you have your stock in a margin account, you've already agreed to let your broker loan it to short-sellers.
Your brokerage firm generates extra commissions by conducting transactions for the short-seller, by loaning the shares to another brokerage firm, or by pocketing interest income from the money generated by the short-seller's stock sale. In theory, you're none the worse off for having someone else trading your shares. After all, they'd just be sitting in your account otherwise. Whenever you want to sell the shares, your broker will manage to have them, even if that means telling the short-seller to return them.
Short-selling isn't for everyone, but the Motley Fool has consistently held that shorting is a viable investment option for experienced investors. The same grasp of fundamental analysis that makes someone a good long-term investor can be used to find overvalued stocks that are worth shorting. Of course, in going long, you risk no more than what you've invested up front. A short has potentially unlimited risk since the stock she shorts at $20 could end up becoming the next Microsoft. For most investors, short sales should constitute no more than 10% to 20% of a diversified portfolio. Also, short-sellers need to be more proactive in cutting losses when they're wrong about a company's fundamentals. Finally, a short-seller also needs to be attuned to market forces that can quickly turn even a dubious outfit destined for bankruptcy into a 300% gainer in the meantime.
The short squeeze is one such force. The essence of a squeeze is that brokers who have loaned out the stock are now requiring short-sellers to return the shares, meaning that the shorts must buy the stock themselves or risk a forced "buy-in" by the brokerage firm. Because brokerage firms aren't very picky about paying a good price on such occasions, the stock can spike dramatically, especially since market makers responsible for providing liquidity for a stock often see forced buy-ins as an opportunity to make a quick killing by temporarily raising their prices. Forced buy-ins may result from a trade going so much against a short-seller that he gets a margin call from the broker to either put up more cash or risk losing the position. Other times, it simply represents a change in short-term supply and demand exacerbated by increased trading volume and rapid turnover.
Let's say a heavily shorted company announces positive news that brings in new buyers. This demand pushes the stock higher, but it also leads some old holders to sell. The stock moves from one broker to another. Short-sellers who had borrowed shares from these old holders may have to cover the short position if their broker can't find new shares for them to borrow. This creates more demand, which pushes prices higher and continues the process. As you might expect, short squeezes often come in waves that attract momentum-oriented investors who see a stock rising and jump on for the ride. This additional demand, in turn, exacerbates the squeeze. Of course, these momentum investors usually jump ship quite rapidly when the momentum changes, adding to selling pressure later.
Conversely, there are also momentum shorts who jump on a sinking ship and then quickly cover their short positions when the momentum shifts. In recent weeks, many favorites of short-sellers -- including Think New Ideas (Nasdaq: THNK), Quadramed (Nasdaq: QMDC), Coinmach (Nasdaq: WDRY), and Source Media (Nasdaq: SRCM) -- have seen short-covering rallies as momentum players close out short positions that proved profitable during the recent market meltdown. Such short-covering rallies can appear indistinguishable from short squeezes and can even trigger a short squeeze, yet they typically are motivated by profit taking after a stock has nose-dived.
Squeezes are most likely to occur with stocks susceptible to these supply/demand imbalances. Some numbers worth checking are: 1) the size of the "float" (the number of shares actively traded and not owned by insiders or investors with a greater than 5% stake in the firm) relative to the total number of shares outstanding; 2) the number of shares sold short relative to the float; and 3) the "short interest ratio," or the number of shares short versus the average daily trading volume (usually expressed as the minimum number of days required for all shorts to cover their positions).
A company with a hot story, a small float, and a relatively high short interest ratio (or a high percent of shares short relative to the float) is a prime candidate for a squeeze. Investors can find Market Guide data for a company's float and shares outstanding by using the snapshot feature at quote.fool.com. Short interest figures for Nasdaq stocks can be attained at ViWes InvestInfo. Also, every month the Wall Street Journal and Investors Business Daily publish short interest figures for Nasdaq and NYSE issues. Although there are no ironclad rules, a stock may become more susceptible to a squeeze when it has a short interest ratio of more than 10 and/or when 25% or more of the float has been shorted. Amazon.com (Nasdaq: AMZN), K-tel (Nasdaq: KTEL), and Inktomi (Nasdaq: INKT) are three recent examples. (Companies with outstanding convertible preferred stock may have a high amount of relatively meaningless arbitrage-related short interest due to the preferred holders' establishment of short positions to hedge their investment risks.)
Online message board participants talk a lot about potential short squeezes. A squeeze may be seen as a way for a beaten down stock to find new life or for short-sellers to get what they deserve. Indeed, management at companies besieged by short-sellers will often attempt to orchestrate a squeeze by encouraging shareowners to "take delivery" of their stock certificates -- that is, to pull their shares out of a margin account from whence they may be borrowed and stick them into a cash account from which they can't be loaned. Optical Cable's (Nasdaq: OCCF) Chair/CEO Robert Kopstein tried this a few years ago as did Chair/CEO John Rendall of the now bankrupt Solv-Ex (OTC Bulletin Board: SOLVQ). (Large institutional investors will themselves occasionally try to create a squeeze in a stock by taking delivery on their own shares.) Since the main way for a company to shake the shorts is to produce great sales and earnings, it's almost always a red flag when management starts attacking short-sellers or spending more than two seconds worrying about them.
Short squeezes are a mixed blessing for long investors. On the one hand, they can quickly send a stock soaring to unbelievable prices that otherwise might not be attained for years, if ever. Investors who keep their heads may find this an excellent opportunity to cash out. Yet those who get caught up in the frenzy can end up worse off. That's because just as the short-sellers created artificial supply earlier, a squeeze creates artificially souped-up demand that eventually dissipates.
Longtime Fools will recall Iomega's (NYSE: IOM) astonishing rise in the spring of 1996 and its sudden collapse. The rally was fueled by massive short covering, momentum players, and huge demand from online investors so captivated by the story that they margined their accounts to buy more shares. After Iomega increased the float by issuing shares in a follow-on stock offering, the squeeze subsided. Without the artificial demand and with new supply, the rally died. That sent momentum investors fleeing and left many online investors suddenly facing margin calls and forced liquidations as the bottom simply fell out.
Shares that have been shorted must ultimately be purchased. That's why some contrarily consider a high amount of short interest bullish. On the other hand, academic studies suggest that most heavily shorted stocks do eventually fall substantially. That's because huge short positions are usually the work of professional short-sellers, most of whom do a lot more due diligence than your average sell-side analyst. That's why it often seems like desperation when investors hope for a short squeeze. It's a bit like hoping for a takeover. If you've reached that frame of mind, you probably need to reevaluate the investment.