What happened

It was a quiet start to the day, with shares of fashion company Revolve Group (NYSE:RVLV) trading around 2% higher. Then out of nowhere, shares quickly flew up 34%. By the end of the trading session, they were still up 25%.

So what jaw-dropping news broke early this morning? Well, nothing. In the absence of news, here's why today's move could be the start of a short squeeze.

Businessmen holding on to arrows that carry them higher.

Image source: Getty Images.

So what

To short a stock, one has to borrow shares and sell them at the current market price. If the price per share goes down, the borrower then repurchases shares at the cheaper price and returns them to their owner, profiting in the process. But it does involve actually buying shares at some point to cover. If too many short-sellers try to cover at once, it creates high demand for the stock, and high demand sends stocks up. This is a short squeeze.

For Revolve Group, over 40% of shares are sold short. That's an indication many investors are bearish on the company. And it's easy to see why. The company withdrew guidance due to the COVID-19 pandemic. Management noted that sales grew 20% year over year in the first two months of 2020, before falling away in March. Furthermore, it's high-end products may not be in demand if we head into a global recession. So the next couple of quarters could be bad.

But with the stock market roaring back to life, many short-sellers could be rethinking their positions. Consider that Revolve Group is an e-commerce platform and its fulfillment centers are still operational. In other words, it's still doing business. And it's set to report earnings next week on May 13. With just a few days before a potential earnings surprise, many short-sellers are likely trying to cover now.

Some consumer discretionary retailers have already reported poor earnings, yet their stocks didn't go down. For example, since The RealReal reported, its stock is up almost 20%. It's possible that Revolve Group will report better-than-feared results, sending the stock higher. That's not what you want if you're a short-seller.

Finally, shares of Revolve Group typically trade on low volume, which amplifies the chance of a short squeeze. Low volume means it takes longer to cover your short position, and can cause panic as short-sellers rush the exits. 

Now what

It can be a fun ride when you're a shareholder of a short-squeeze stock, but it's not something that long-term investors should focus on. If I held shares of Revolve Group, I would be looking at active customers when the company reports earnings. Active customers grew 27% from 2018 to 2019. We know the financials will be disappointing. But was the company able to grow active customers somehow, or at least find ways to engage its audience during this time? To me, this is an indicator of how quickly it can recover once the coronavirus has passed.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.