The recent short-squeeze phenomenon that sent stocks like GameStop (GME 1.50%) and AMC Entertainment (AMC -0.88%) soaring left many investors scratching their heads and wondering how short squeezes work. What causes a short squeeze to start? And how high can stocks go during short squeezes?

In this Fool Live video clip recorded on Feb. 8, contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss the mechanics of a short squeeze and what investors should know about how they work.

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Jason Moser: Short squeezes have taken front and center of the conversation here lately with everything that's been going on with Reddit, and GameStop, and AMC. It's been a fascinating time. It really, I think, shows the power of network effects from a different angle. I mean, this shows the power of network effects and how we're always looking at that network effects as a potential competitive advantage for our investments, but this shows how investment or network effects can be an advantage for investors. In this case, it's had a material impact on a couple of companies, GameStop, and AMC. Now, you've done some digging into the financial space however, and you found some companies in our space with a pretty high short interest. So I want to get into that, and before we do, real quickly just remind our listeners. For those who aren't familiar, remind our listeners what a short squeeze is.

Frankel: So first of all, short interest. It's a measure of a company's shares that are currently sold short as a percentage of the float. The float means all the shares that are available to trade.

Moser: Yeah.

Frankel: There are lot of shares in a lot of companies that are not available for trade, like some owned by insiders and things like that that can't be readily transacted. So if a company has 10 million shares of its float and 5 million are sold short, that would be a short interest of 50%.

Moser: That would be a lot too, and that's a lot.

Frankel: Yes. I generally consider anything over 10% to be elevated short interest. There's no set-in-stone rule. That's just my own rule of thumb. If I see a double-digit short interest, that means a lot of people are betting the other way.

Moser: Sure.

Frankel: I mean, there's a million different ways it can occur and no one's ever seen anything like the Reddit squeeze before. But there's generally a few different steps of these happening, and this is no exception in this situation. Step number one, a lot of people bet against the stock. Usually when you see a big short interest, it means big investors are betting against it, like hedge funds. For whatever reason, they're betting against it. Normally, it's a legitimate reason. They think it's overvalued, they think the business is going to be in decline. Like in AMC's case, they thought people might not going to see movies anymore.

Moser: Sure.

Frankel: GameStop; a lot of hedge funds thought that no one's going to buy video games in stores anymore, and they have a point. For one reason or another, a lot of people are betting against the stock. Number two, some event happens where a lot of buyers flood into the stock. That could mean a lot of people on a Reddit thread kind of ganging up, that could mean actual good news for the company like when AMC said that they were avoiding bankruptcy. That was actually good news.

Moser: Yeah.

Frankel: The COVID vaccine came out.

Moser: A good earnings report even.

Frankel: Sure, a good earnings report. The vaccine news created the short squeeze on a lot of the real estate stocks we cover when people realized that the pandemic wasn't going to last forever. Some good event happens that leads buyers to flood in. The people who haven't sold short are seeing their positions really decline in value, or the amount they owe to cover their shorts is really getting high.

Moser: Yeah.

Frankel: Either by choice or by force, if the losses get too bad, a broker will force them to cover. You'll see a lot of these big investors start to buy shares to cover their shorts, which in turn creates even more upward pressure on the stocks, and you just see this cascading domino effect, which is how a short squeeze pushed a stock like GameStop whose business is not worth anything close to $400 a share. [laughs]

Moser: Yeah.

Frankel: It's how it pushed that stock from $2 a share to over $400 a share in just a few days. It's because of that domino effect of one short seller is forced to cover. Covering a short involves buying shares, so that adds more pressure and puts the price higher. The next short that really was holding out has to cover, and so on, and so on. I mean, the short sellers, not people, hedge funds lost billions of dollars on their shorts. That's the basics of how a short squeeze works.