Forced to Launch: What’s a Short Squeeze and Why Do They Happen?

When a stock suddenly enters a hyperbolic rally without clear fundamental reasons, it could be a classic “short squeeze.” Learn what a short squeeze is and how some investors approach them.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Skyrocket: stock in a short squeeze
5 min read
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Key Takeaways

  • A stock that rallies hyperbolically when there’s no news could be going through a “short squeeze”
  • Learn why this sometimes happens—what is a short squeeze?

  • A short squeeze can potentially be worth trading, but only with great care

Coming up short. Getting the short end of the stick. Short-sighted.

Those trite expressions might describe how people who piled into short positions on a particular stock might feel if shares suddenly skyrocket in a rally that’s nothing short of hyperbolic. Especially if the rally seems to come out of the blue, with no fundamental news affecting the stock.

When this happens—as it did, for instance, with Tesla (TSLA) in early 2020—the consequences can be brutal for anyone on the wrong side of the trade. Those with a short position (meaning they won’t profit unless shares fall) can find themselves either holding on for dear life or forced to jump ship before potential losses pile up too high. In TSLA’s case, the heavily shorted stock rose as much as 20% in a day. Imagine being someone who had bet against it.

Why would something like this happen to TSLA or any other stock? There are a bunch of possible reasons, but a “short squeeze” is one of the main ones. 

Classic signs of a short squeeze can include a dynamic narrative, a case for massive growth as well a case for financial stress, and deep pockets lined up on both sides of the trade.

Here’s how to identify a short squeeze and how you might want to play it (or not). 

The Short Squeeze Explained

You’re probably familiar with the terms “short selling,” “going short the stock market,” “shorting a stock,” or “selling stocks short.” The aim when shorting a stock is to generate profit from stocks that decline in value. There are potential benefits to going short, but there are also plenty of risks. One big risk is when bullish news pushes a stock price higher, prompting short sellers to head for the exits all at once. As the shorts scramble to buy back and cover their losses, upward momentum builds on itself and the stock can move sharply higher. 

This is known as a short squeeze.

What makes a short squeeze so dangerous? Think of it this way: When you buy a stock, the worst thing it can do is go to zero. Sure, in some of today’s big-name stocks such as Google parent Alphabet (GOOGL) and Amazon (AMZN), which have shares trading around $1,500 and $3,200 per share respectively, it can be a long way to zero. But still, the upside is unlimited. If a stock has a growth narrative and there are enough believers, today’s share price can go well beyond what looks reasonable by traditional fundamental metrics.

On the other hand, to quote the old adage (widely attributed to economist John Maynard Keynes in the 1930s), “the market can stay irrational longer than you can stay solvent.” Even if a highflier does come back to earth in the long run, the shorts may be wiped out long before then. (Or, in another quip by Lord Keynes, “in the long run, we are all dead.”)  

With TSLA in 2020, there were all the classic signs of a short squeeze. People were covering because they had to. And that can cause things to get out of whack—when people make trades they don’t want to, but must.

When a stock suddenly climbs like a rocket even without good news, ask yourself, “Who would buy shares up here?” The answer? Someone who’s forced to. Someone who doesn’t have enough money to hold on any longer, or whose pain threshold has been violated.

The Squeeze Is On?

Again, shorting a stock is a complicated business. Because you can’t sell something you don’t own, shorting requires the seller to “borrow” the stock (and pay interest to the stock lender), then sell it. Locating the shares can sometimes be difficult for your clearing firm because of high demand or a small number of outstanding shares, or “the float” (see figure 1).

Measuring a short squeeze can involve a metric called the short interest ratio, aka “days to cover.” It indicates, in days, how long it would take to cover or buy back all the shorted shares. Basically, you divide the number of shares sold short by the average daily trading volume. The more days to cover, the more pronounced the effect can be.

Fundamental data for traders

FIGURE 1: VOLUME AND FLOAT. Fundamental data available on tdameritrade.com can help you analyze the dynamics of a stock’s price action. Source: tdameritrade.com. For illustrative purposes only. Past performance does not guarantee future results.

Technical Analysis and Short Squeezes

When markets have explosive activity, it’s easy to see in hindsight. But there are also tools that can help identify when momentum builds up so you don’t end up on the wrong side of the trade. On the thinkorswim® platform from TD Ameritrade, an indicator called TTM Squeeze can help highlight when the transition between a consolidation and a trend is likely to take place. To see it, pull up a chart from the Charts tab on thinkorswim and select Studies > Add Study > All Studies > T–U > TTM_Squeeze. In figure 2, the TTM Squeeze is plotted in the subchart below the price chart. 

Short squeeze and TTM indicator

FIGURE 2: SQUEEZE ILLUSTRATED. After a period of compression, Tesla stock (TSLA, candlesticks) started showing signs in early 2020 that perhaps it would start making an upward move. In early October 2019, the TTM Squeeze indicator (subchart) showed momentum building up in the stock. This coincided with the stock moving above its 20-period moving average (blue line). The stock continued its upward move and then exploded well above the moving average. Data source: Nasdaq. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

The Short Squeeze Hall of Fame

In addition to Tesla and the drought-led short squeeze in the grain markets in 2012, there have been quite a few instances when shorts piled in, only to wave the white flag after a monster rally.

In one famous short squeeze back in October 2008, Volkswagen—a decent-sized company but normally not one people tend to think of as a market juggernaut—temporarily became the world’s most valuable company as it rose to 1,005 euros per share from just over 210 in less than two days.

The value of Volkswagen shares hit $370 billion, which at that time was enough to top Exxon Mobil’s (XOM) $343 billion market cap. Shorts scurried out of VW shares as short sellers caught betting on a price drop with borrowed stock scrambled to find shares after a buying spree by Porsche, as Reuters reported at the time.

Another famous story includes a pair of New York railroad squeezes beginning in 1863 (“Harlem Corners 1 and 2”) that pitted Cornelius Vanderbilt against several rivals who tried to short his New York & Harlem railway into bankruptcy. With his combination of market savvy and deep pockets, “Commodore” Vanderbilt walked away the victor.

The indicator (dots along the zero line) is plotted with a momentum oscillator (cyan vertical bars). Notice how the oscillator gradually started moving above the zero line and the histogram bars were getting taller? This indicated a possible buildup of momentum. The dots plotted on the zero line are green, which suggests the market is ready to trend. Red dots suggest the market is tightening. If momentum is above the zero line, the direction of price movement is up. When it’s below the zero line, price movement is likely to be down. It may be helpful to plot an additional indicator such as a moving average to confirm the trend.

In this case, the momentum was clearly building for an uptrend. The momentum became extremely strong, pushing the stock price significantly higher. When might it slow down? Keep an eye on the TTM Squeeze indicator.

Fundamental Files

If you’re buying a stock that seems to be in the throes of a short squeeze, especially at high levels, it helps to understand any other reasons why the stock might be moving. 

Consider checking the fundamentals. Is there anything that makes you want to own the stock? You’re not just tempted to buy it because everyone else is, right? Always do your homework. And remember, there’s no need to go all in. A stock that’s in a short squeeze may still have a long way to climb, and if you don’t think the fundamentals support higher prices, then perhaps you should look elsewhere.

In the case of TSLA in 2020, there were some positive fundamentals underlying the short squeeze, including the company’s more consistent profitability and hopes of it being included in the S&P 500 Index (SPX). The stock saw its share price run up to nearly $1,000 in early February, then roll all the way back down to $350 by mid-March (although that drop was probably related in a big way to the pandemic that punished the entire market that month).

TSLA then slowly ground higher through spring and hit new highs by summer. This isn’t necessarily how things typically go after a short squeeze. Your mileage may vary, as the commercials always say.

Other stocks that were caught up in short squeezes haven’t always fared so well, in part because they didn’t have the fundamental support. As with the famous Dutch tulips, there was a vast crater waiting for those who held on too long. 

Playing the Squeeze? Hope You’re Comfortable with Risk

So you say you want to play a stock during what might be a short squeeze? Here’s some stuff to consider.

Trading such a stock is okay as long as you understand the risk and how to control it. You can make small or big bets, but you have to control the risk and limit it. Decide how much money you can lose in any trade.

Also, don’t underestimate how far things can go and how long it can take. When a stock gets caught up in a short squeeze, analysts generally expect it to correct eventually, but to what price and when? Those are the questions no one can answer.

These things can drag on. Just look at the drought of 2012 in the grain markets. Grain futures rose further than anyone thought they could and stayed there awhile. It was a short squeeze based on lack of volume, a drought that caused demand to go crazy, and speculation running rampant.

You might consider playing a short squeeze in the options market. There’s a piece of classic advice about limiting risk: Want to get short exposure? Consider buying a put or put vertical, or selling a call vertical. (Here’s more about limited-risk options strategies.) 

And remember: A short squeeze doesn’t last forever and should eventually subside.

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Key Takeaways

  • A stock that rallies hyperbolically when there’s no news could be going through a “short squeeze”
  • Learn why this sometimes happens—what is a short squeeze?

  • A short squeeze can potentially be worth trading, but only with great care

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