Investors are rushing into marijuana stocks, as the prospects for explosive growth in the cannabis industry loom in the immediate future. With pot slated to become available for recreational use in Canada by the middle of October, those seeking to profit from the marijuana producers that want to supply the budding Canadian market have caused share prices to soar.

Sometimes, the moves that marijuana pioneers like Canopy Growth (CGC -3.19%), Aurora Cannabis (ACB -3.50%), and Tilray (TLRY) make in the course of a single day seem beyond belief, especially in the absence of major news about the fundamental prospects for their respective businesses. Just today, Tilray jumped more than 50% when trading opened, despite having no new announcements since the market closed the previous day.

Marijuana leaf on top of a $100 bill.

Image source: Getty Images.

Yet what investors in marijuana stocks need to understand is that behind the scenes, there's a massive tug-of-war going on, and short-term traders with sharply different beliefs about the future of the marijuana industry all want to make money at each other's expense. In particular, those betting against pot stocks are selling shares short, and while that could make them rich if their skepticism about marijuana proves correct, it also leaves them vulnerable to an event known as a short squeeze.

How shorting stocks works

The idea behind selling any stock short is pretty simple. In order to sell a stock short, you first have to find someone from whom you can borrow shares. Typically, your broker will handle the logistics of finding that shareholder -- most often, another client of the same broker -- and obtaining the shares. Then, you sell those shares on the open market.

Ideally, your goal with a short sale is to replace the stock at some later date after the share price has fallen. For instance, if you sell a stock short at $200 per share and the price falls to $125, then you can buy back the stock, return it to the shareholder you borrowed it from, and pocket the $75 per share difference as profit.

The potential profits from short-selling don't come without risk. If the stock price rises, then you'll eventually have to spend more to replace it than you received when you sold it -- and that extra money has to come out of your own pocket. With no theoretical limit to how high a stock price can soar, your potential losses from your short position are similarly unlimited.

What's a short squeeze, and why does it happen?

In isolation, any single short sale doesn't have a huge impact on the overall market for that stock. However, when a stock becomes a popular target of short-sellers, traders find out about it, because major stock exchanges keep tabs of how much short-sale activity is associated with each stock and regularly report those figures. If bullish traders can put enough pressure on short-sellers, then a short squeeze can occur.

In a typical short squeeze, some piece of news or other catalyst sends the stock price significantly higher. Short-sellers then face a tough decision: Buy shares to close out their short positions at a loss, or hold on and risk even bigger losses. Shareholders know that short-sellers are trying to close their positions, so they hold out for even higher prices, continuing the cycle and putting even more pressure on short-sellers.

Even worse for short-sellers is the fact that they don't always have a choice in deciding to buy back stock. If losses mount to the point at which short-sellers have insufficient margin with their brokers, then they'll be subject to a forced transaction. Moreover, if the investor from whom you borrowed the shares wants them back, your brokerage agreement will typically make you close your position by repurchasing the stock -- no matter the price.

Don't get cocky

For investors who don't understand the dynamics of short-selling, a soaring stock can seem like validation of their investing thesis in a particular company. With marijuana stocks in particular, even stratospheric gains can seem warranted if you focus on the long-term future of the nascent recreational-pot industry.

The problem is that short squeezes inevitably end. When short-sellers are all forced out of their positions, there's no one left to buy shares at their now-lofty prices -- but there are plenty of investors who are happy to sell their stock at a huge profit. The short squeeze typically finishes with a dramatic plunge in the share price back toward the levels that prevailed immediately before it started.

Marijuana stocks are prone to be volatile for the foreseeable future, and some of those moves will be legitimate responses to important news items regarding the companies and the industry. However, many of the moves you'll see on a daily basis have little to do with marijuana producers or their business prospects and everything to do with traders of the shares. By keeping an eye on short-selling interest in marijuana stocks, you'll be prepared for short squeezes when they come -- and the inevitable aftermath when they're done.