What is it that could put an inventory on a meteoric rise? In 2021, we saw a number of stocks make truly staggering jumps, doubling in price on consecutive days. There are several 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 has been around provided that shorting stock.
What is a short squeeze?
Shorting a stock involves borrowing the stock, usually from a broker, and selling it now assured of buying it back later for less in order to make a profit.
A short squeeze is when a shorted stock's price rises as opposed to down, forcing the short seller to determine between covering their position by continuing to pay interest on the borrowed shares assured the price should go down or exiting their position by buying shares at the new 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 get stock. And due to the nature of calls, when the price of the underlying stock rises, the market makers have to get more stock to keep hedged.
We may call this the decision option squeeze.
The issue is these moves aren't based on any fundamental changes in the stocks.
Very little has changed for GME stock since it was a $4 stock, and certainly not since it was a $16 stock.
Brokerage firms are extremely concerned with the volatility of these moves, as they know they could face losses if customers can't cover positions. They started limiting the positions that can be taken in several of those names.
That news came on Jan. 28, 2021, which saw GameStop stock price range from over 500 to below 115.
This can be a trade you wanted to watch out for. Though some hedge funds were hurt and some retail traders made fortunes — at least written down — this still may end badly.
The bottom line
A short squeeze is bad news for brief sellers and good news for investors going long. The "squeeze" forces short sellers to get, raising the price of the stock, which causes them to lose money. Investors (buyers) benefit while the stock price goes higher. As more short sellers exit, the price goes higher causing short sellers to lose more and buyers to achieve more.
Watch for some of the indicators that the shortsqueeze may be coming, such as increased buying pressure, high short interest, days to cover above 10, or an RSI below 30. Most of all, you ought to understand that the possibility of a short squeeze makes short selling risky. Don't go there until you understand and accept that risk.
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