Please ensure Javascript is enabled for purposes of website accessibility

How Short Squeezes Start and Why They Can Drive Stocks So High

By Matthew Frankel, CFP® - Feb 18, 2021 at 8:08AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Short-selling happens all the time, but what makes it lead to a short squeeze?

The recent short-squeeze phenomenon that sent stocks like GameStop (GME -3.56%) and AMC Entertainment (AMC -8.03%) 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.

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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

GameStop Corp. Stock Quote
GameStop Corp.
$95.66 (-3.56%) $-3.53
AMC Entertainment Holdings, Inc. Stock Quote
AMC Entertainment Holdings, Inc.
$12.03 (-8.03%) $-1.05

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/22/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.