What is it that will put an investment on a meteoric rise? In 2021, we saw numerous stocks make truly staggering jumps, doubling in price on consecutive days. There are many factors that contributed to these gargantuan moves, but one is surely the classic short squeeze.
While there are several new factors at play in the markets today, the short squeeze 's been around so long as shorting stock.
What is a short squeeze?
Shorting a stock involves borrowing the stock, usually from the broker, and selling it now assured of buying it back later for less to be able to make a profit.
A short squeeze is each time a shorted stock's price rises rather than down, forcing the short seller to choose between covering their position by continuing to pay interest on the borrowed shares assured the cost will go down or exiting their position by buying shares at the newest higher price and returning them at a loss.
What Is Delta Hedging, And Why It Matters In A Short Squeeze
Delta hedging requires the market makers to buy stock. And because of the nature of calls, when the buying price of the underlying stock rises, the market makers have to buy more stock to remain hedged.
We might call this the call option squeeze.
The issue is why these moves aren't centered on any fundamental changes in the stocks.
Very little has changed for GME stock since it absolutely was a $4 stock, and definitely not since it absolutely was a $16 stock Learn More.
Brokerage firms are extremely concerned about the volatility of those moves, because they know they could face losses if customers can't cover positions. They started limiting the positions that can be taken in a few of these names.
That news came on Jan. 28, 2021, which saw GameStop stock price range from over 500 to below 115.
This is a trade you wanted to watch out for. While some hedge funds were hurt and some retail traders made fortunes — at the very least written down — this still may end badly.
The bottom line
A short squeeze is bad news for short sellers and good news for investors going long. The "squeeze" forces short sellers to buy, raising the buying price of the stock, which causes them to lose money. Investors (buyers) benefit as the stock price goes higher. As more short sellers exit, the cost goes higher causing short sellers to lose more and buyers to get more.
Watch for some of the indicators a short squeeze may be coming, such as increased buying pressure, high short interest, days to cover above 10, or an RSI below 30. Primarily, you need to realize that the chance of a short squeeze makes short selling risky. Don't go there unless you understand and accept that risk.
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