Anyone who wants to profit from a price drop can go short. A short-seller sells shares that they do not own but borrows from other investors, such as pension funds. If the price subsequently falls, the short-seller buys the shares back at the lower price and gives them to the lender. The difference between the sale and purchase price is the profit for the short-seller. But if the price rises, the short-seller suffers a loss because they have to buy back the shares at a higher price.
Professional investors, such as hedge funds, often engage in short selling. This is because the risks are high. Investors who simply buy a share, or go long, can, in the worst case, lose their investment if the price goes all the way to zero. But because the price of a stock has no limit upwards, the theoretical loss for a short-seller is unlimited. To limit the potential loss, most short-sellers use a stop-loss order. Positions are then automatically closed when the price hits a certain level.
What is a short squeeze?
A short squeeze is the worst nightmare for short-sellers. It happens when short-sellers are surprised by a sudden sharp rise in the price, for example, if good news about the company unexpectedly comes out. They then unintentionally have to buy back shares at lightning speed in order to avoid losses or to safeguard their profits. The purchases cause the price to rise, which, in turn, causes other short-sellers to close their positions. This creates a snowball effect of rapidly rising prices, reinforced by the stop-loss orders. The explosive price rises ensure as it were, that the short-sellers are squeezed out of their positions.
Conditions for a short squeeze
A short squeeze cannot occur with every stock. There must already be many short positions outstanding. The more short-sellers there are in the stock, the greater the chance of a short squeeze. This happened, for example, with GameStop (GME). In the spring of 2020, the number of shorts stood at over 100%. In other words, more short positions had been taken than there were freely tradable shares. The American computer game chain thus formed an ideal target for investors to cause a short squeeze. On the online forum Reddit, private investors drove the price up by hundreds of percent, and short-sellers were forced en masse to take their losses. Companies in which more than 10% of the shares are short positions and with a market capitalisation of less than €1 billion are most at risk of a squeeze.
In Europe, short-sellers are required to disclose their position as soon as it exceeds 0.5% of the issued capital. This is calculated by looking at all long and short positions in shares and derivatives in the company concerned.
Volkswagen short squeeze
One of the biggest short squeezes took place in Volkswagen shares in 2008. Hedge funds thought that the German carmaker would not survive the major financial crisis and speculated massively on a price drop. A large short position was built up, up to approximately 12.5% of the number of outstanding shares. At the same time, rival Porsche increased its minority stake from just over 40% to 74% of Volkswagen shares through options. When this became known, the short-sellers fled from their positions. Within five days, Volkswagen's share price increased fivefold to €999. This even made the group the largest company in the world.
Risks of a short squeeze
Taking part in a short squeeze can potentially yield a lot of money, but it also involves high risks. It mainly comes down to good timing. For example, during GME’s short squeeze, prices skyrocketed to $347.51 on January 27, 2021. However, a week later, on February 4, the price was already sharply lower at $53.50. This is a clear example of the fact that once most short-sellers have closed their positions, the price often collapses again.
Profiting from a short squeeze
Short squeezes are quite unpredictable. The most shorted stocks offer the best profit opportunities. As mentioned, the more short positions, the greater the chance of a short squeeze. Therefore, keep an eye on the public records. If the overall short position exceeds 20%, this could indicate an impending short squeeze. For smaller stocks with a market capitalisation of less than €1 billion, the chance of a short squeeze is more pronounced than for large caps. This is because the marketability of smaller listed funds is less good, and the price is therefore easier to influence. If demand rises because short-sellers have to buy back their borrowed shares en masse, the price of an illiquid small-cap can explode.
In that context, the so-called 'short interest ratio' is also important to keep an eye on. This indicator shows the ratio between the number of shares shorn and the daily trading volume in the stock.
Let's take Wereldhave as an example. Approximately 10.6% of the issued share capital is shorted, or about 4.2 million shares. The daily trading volume over the past three months was 150,000. That amounts to a short interest ratio of 28. In other words, short-sellers theoretically need 28 days to fully run down their short positions. The longer it takes to unwind positions, the more vulnerable the stock is to a short squeeze. At a short interest ratio of more than 7, short-sellers are likely to have difficulty closing their positions. Trading volumes can change quickly, by the way, and so can the short interest ratio. So always compare short positions with current trading volumes.
Technical analysis can also be a good tool. The RSI, or Relative Strength Index, measures the market sentiment and can determine the right entry moment. A low RSI of less than 30 indicates an oversold situation, which can result in a price increase and thus possibly a short squeeze.
Sources: Investopedia, FD, shortsell