Before you can understand the short squeeze, you need to understand shorting. (For a quick refresher, pop over to this article.) In a nutshell, short-sellers, expecting a stock to fall and hoping to profit from that, have all borrowed shares and sold them, planning to replace what they borrowed by buying shares later, at a lower price.
Of course, things don't always go their way. Sometimes a stock keeps rising, forcing short-sellers at some point to throw in the towel and buy the replacement shares at a higher price than where they sold the borrowed shares.
A short squeeze happens when those who are short a stock bail out en masse, driving the stock price up as they buy shares to replace the ones they borrowed. This can be good, if you happen to be long the stock (i.e., you've bought shares as most investors do, holding them and expecting them to eventually rise). It can be bad if you're one of the short-sellers, though, or if you had planned to buy shares of the stock but at a lower price.
Here's how a short squeeze scenario might play out. Imagine Chihuahua Channelers Inc. (ticker: YIPYIP), which helps people communicate with long-lost pets. Let's say it's very heavily shorted by investors who believe the company and stock are in for a beating. If, for some reason, the stock price begins to soar, these short-sellers will be in a tough position. They might hang on, watching their investment move farther and farther into the red. Or, they can close their short position by buying shares to replace the ones they borrowed.
As the stock price rises, more short-sellers will cut their losses and buy shares to close out their short position. This will push the stock price up even higher. As the price keeps climbing, even more short-sellers will choose to bail, buying more shares. And, voila, you've got a short squeeze.
Some stocks that currently have a lot of short interest include Pre-Paid Legal Services
You can learn more about shorting in our shorting FAQ and about how the financial world works in our Fool's School. Check out our highly regarded How-To Guides as well. They can help you learn to make sense of financial statements, among other things. To learn to more about brokerages and possibly find a better brokerage for yourself, check out our Broker Center.
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