What Is a Short Squeeze?

This year has been big on the short squeeze, a phenomenon that occurs within the stock market when conditions are right. A short squeeze can happen when a stock has a high number of shares sold in short positions and a large number of other investors buy shares, driving up the price rapidly. 

Investors may hear stories like that of one Dubai resident who made a $65,000 profit in one week from his GameStop (NYSE:GME) trading early in 2021. Short squeeze involvement doesn't always turn out so favorably for investors, so here's some info to help you analyze the market conditions for yourself. 

How does a short squeeze work?

A short squeeze must begin with a high percentage of short interest in the company. Investors will borrow a stock they expect to drop lower in price, then sell it to buy it back at the lower price. This is called shorting.

In a short squeeze, an asset that short sellers expected to drop in price may start rising unexpectedly, possibly due to good news about the company or pressure created through online communities. The higher the share price goes, the more short-sellers will be "squeezed" out of their positions, forced to sell to minimize losses. 

Short squeezes tend to build momentum by causing more and more short sellers to exit positions. This drives the price up even further, fueling the motivation for other investors to buy in hopes of capitalizing on the opportunity.  

Top short squeeze stocks of 2021

Some of the stocks that had the biggest swings due to short squeezes in 2021 shot up enormously. Video-game retailer GameStop was one stock that experienced the most dramatic volatility in January, along with movie theatre company AMC Entertainment (NYSE:AMC). Within the first half of 2021, short sellers of GME and AMC had lost a combined total of $12.3 billion. 

Sometimes, short squeeze stocks like GME and AMC are what's called "meme stocks." These are stocks hyped up by social media communities who want to punish hedge funds and help retail investors make more money. 

Signs that a short squeeze may happen

For investors hoping to make a quick trading profit, there are signs to look for (although these are not guarantees the stock will perform a certain way):

• Is the stock's short interest higher than usual? Short interest is the total number of shares of a stock that have been sold short. 

• The short interest ratio divides the number of short shares by the stock's average daily trading volume. A high short interest ratio (above 10) can indicate a potential short squeeze. You can find this in a stock chart's statistics.

• Relative strength index (RSI) below 30 can be a signal of a coming price increase, which may cause a short squeeze. 

Risks of a short squeeze

Although some investors can make a profit by buying shares of a short squeeze, it's a risky way to invest. Timing is extremely important – you must get in when the price is low enough to allow plenty of growth, but exit and sell in time to lock in profits. The difference could be seconds in a high-pressure market.

Your best bet? Test the short squeeze strategy out on a small scale with money you're willing to lose.