It's been a while since short squeezes were in the news, but they're seemingly back. The market has built solid momentum in recent weeks, and troubled online car dealer Carvana (CVNA 5.19%) has seen its stock nearly triple year to date, with the bulk of its gains coming in the past week.
The stock is still down a whopping 96% from its all-time high, so there is room for it to continue running. But does that mean you should chase the potential returns?
Feeling the squeeze
Investors can borrow shares (typically from a broker) to sell them, a process known as shorting. A short seller's goal is to buy the shares later at a lower price, profiting from the difference. Buying shares to repay the broker is called covering a short. When many investors have shorted a stock, a rising share price can result in those investors scrambling to cover their short positions, resulting in a surge of demand for that stock. This is known as a short squeeze.
Much like frenzied buyers can keep pushing a stock higher, Carvana's stock has been pushed to its deepest lows by short sellers. You can see below how the percentage of shares sold short has climbed over the past year:
Data by YCharts.
But growth stocks across Wall Street have risen a bit from their lows, a potential sign that investors are dipping their toes back into riskier stocks. And as Carvana gains some positive momentum, short sellers are rushing to cover their positions. Short squeezes aren't a science, and both sides of this dynamic are very speculative.
Be wary of weak fundamentals
More importantly, a stock's underlying fundamentals will be the primary driver of its share price over time. Carvana is indeed struggling right now, which explains the heavy short-selling activity.
For example, its financials remain distressed. It has $7.4 billion in debt against just $316 million in cash and equivalents. Meanwhile, it has burned through $2.4 billion in cash over the past four quarters.
Data by YCharts.
The company faces a potential bankruptcy if it's unable to service its debt. If that happens, shareholders often get wiped out, even if the business emerges from bankruptcy court. Carvana will remain a risky stock until management can put together several quarters of positive free cash flow, which might not happen before its cash runs out.
So, Carvana faces an uphill battle, despite its stock's recent surge. Used car prices are plummeting, which will further squeeze profit margins for the company.
Will the stock continue climbing?
You want stocks that go up because the business has robust financials or strong prospects, not because of something unsustainable like a short squeeze. The stock could continue climbing higher, but you don't know when the music will stop.
Chasing quick gains from a short squeeze isn't investing -- it's gambling. You can participate as long as you understand the substantial risks involved and only use money you can afford to lose. You should look elsewhere if you're trying to identify long-term investments that can build wealth for you over time.
