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When investors take a “short” position on a stock, they essentially bet the stock price will fall. This involves borrowing shares, selling them, and aiming to buy them back later at a lower price. However, heavy shorting activity can sometimes lead to the opposite- sharp buying spikes that send the stock price surging rapidly upwards. This can occur through two related but distinct events: short squeezes and short covering.
How short selling works
Short selling involves experienced traders temporarily borrowing shares to immediately sell them at current market prices while planning to repurchase later at lower prices, pocketing the differential as profit. However, unlike regular trades, the risk of losses remains unlimited if share prices continually move against expectations instead of dropping when rebuying is needed. Hence, rigorous risk management protocols plus advanced technical and fundamental analysis proficiency are mandatory before attempting short trades.
Understanding short covering
Short covering refers to traders with active short positions buying back shares to exit trades to contain losses if markets turn unfavourable gracefully. This buying activity often fuels further brief price spikes amid short-term supply shortages. When short covering volume surges drastically, it generally indicates exhaustion of bearish sentiment with the possibility of an upward reversal as most speculative traders have exited sell trades. However, one must be cautious against irrational exuberance manifesting periodically during such rebounds.
Impacts of short covering on markets
When a significant amount of short covering happens simultaneously, it can generate additional upward momentum in stock prices. As short sellers scramble to buy shares to cover their short positions, this additional demand can swiftly drive prices higher.
This price acceleration due to short covering is known as a “short squeeze.” While some short squeezes fade quickly, large and forceful short squeezes can be sustained longer. This continued buying pressure maintains the power of the short squeeze for days or even weeks at a time.
The rapid price spikes caused by short squeezes can disrupt normal market behaviour in the short term. High levels of short interest make stocks more vulnerable to extreme volatility triggered by short covering.
However, after an intense squeeze, activity tends to normalise again. While they last, short squeezes can see eye-watering gains – handing profits to long investors but causing significant losses for overexposed short sellers caught on the wrong side of the trade. Thus, the short covering can sharply amplify price gains, but these may prove short-lived.
Understanding short squeezes
Under specific conditions of overcrowded short positions coinciding with an unexpected positive trigger like blockbuster firm news, share prices can spike steeply before bearish traders can react, forcing them to cover rapidly to stem spiralling losses. As more rush to cover short trades simultaneously, it intensifies tremendous upward pressure and volatility – triggering the phenomenon known as a short squeeze. The resultant media hype and reactive retail purchaser euphoria then sustain the massive price spikes for prolonged periods with irrational zeal.
How do short squeezes work?
Since short squeezes can witness truly atypical volatility stretches that defy sane analysis, it becomes prudent not to time entries during the phenomenon based on predictive abilities alone and remain decisively avoidant of herd mentalities. While occasional opportunities for short-term trades relying on momentum technical indicators may emerge for experts, long-term investors would be wise to stay out amid clearly irrational exuberance, identifying a squeeze until stabilisation reappears, allowing fundamentals to rule pricing again.
Difference between short squeeze and short covering
A short squeeze happens when a stock with an unusually high percentage of shares sold short experiences a sharp price increase. This forces short sellers to scramble to buy back the shares they initially bet would fall in price to close out their short positions and limit losses.
For example, GameStop had over 100% of its available shares sold short in early 2021 based on high short interest. When some positive news triggered a small rise in the stock, short sellers rushed to exit their positions and buy back shares before the price rose further. But this flood of buying itself drove the price up even higher very rapidly. As more short sellers bought to cover, it spiralled into a feedback loop – sending the stock price exponentially higher within days. This is the intense, cascading phenomenon known as a short squeeze.
By contrast, short covering refers to routine buying to close out short positions during normal market conditions. Short sellers bet on declines in stocks, so if a stock moves slightly up, some traders will voluntarily choose to cover, i.e. buy back shares to lock in profits from their initial short sale. This buying pressure from short covering can add a modest uplift to the stock price. However, unlike a volatile short squeeze, short covering tends to happen steadily over a longer period.
The key difference is a short squeeze is an intense, cascading event usually triggered by an external event like good news. Short covering is more mundane traders closing positions during regular market conditions. A short squeeze is a spike, while short covering is usually slower and steadier buying. Both lead to buying pressure on a stock, but a short squeeze leads to an abrupt and extreme price spike.
Conclusion
Short covering is normal traders closing out short bets during regular market conditions, perhaps if a stock inched slightly higher. This steadier buying can provide a modest lift to the stock price. On the other hand, a short squeeze is an explosive short-term event triggered when a heavily shorted stock suddenly jumps higher on positive news or a catalyst. The resulting rush of short sellers scrambling to exit their bets and buy back shares creates a cascading feedback loop – shooting the stock price up exponentially within days or hours.
FAQs
A sharp rise in a heavily shorted stock, often due to positive news, forces short sellers to scramble to close positions. Their simultaneous buying drives prices up further.
Yes, closing short positions involves buying stocks, which adds modest upward pressure on prices through increased demand.
No, short squeezes occur due to natural market dynamics and sentiment shifts around a stock. They are not considered illegal manipulation.
No, genuine short squeezes are quite rare. More routine short covering happens much more often.
From a few days to a few weeks typically. Intense upward momentum fades once short covering is exhausted.
Yes, huge profits can be captured by buying a stock undergoing a squeeze early and selling into the rapid price surge. But timing entries and exits ideally are tremendously difficult.