Difference Between a Short Squeeze and Short Covering

5 mins read
by Angel One

What is the definition of short covering?

When investors sell a stock they do not own, this is referred to as selling the stock short. Exiting a short position is accomplished by purchasing the borrowed shares and returning them to the lender, a process known as short covering. Once the shares are returned, the transaction is over, and the short seller has no further duty to the broker. In essence, short selling is a strategy for betting on a stock’s price collapse.

Traders cover their short positions for a variety of reasons. If the stock price falls as predicted by short-sellers, the company’s shares can be purchased for less than the trader pays the brokerage for the borrowed shares. They are covering the short, in this case, resulting in a profit for the trader. Short sellers are well aware that shorting a company offers the possibility of unlimited losses, as their downside risk is equal to the theoretically unlimited upside of the stock price. A rising stock’s price can also induce traders to close their short positions to minimise losses.

How short-covering operates

Assume you have a strong suspicion that BadCo’s stock price, which is now trading at $50, is about to fall. You sell 100 shares of BadCo short — that is, borrow from a broker and resell — at $50 per share, earning $5,000. When BadCo’s share price falls to $40, you purchase 100 shares for $4,000. You return the 100 borrowed shares to your broker to close your short position, earning a $1,000 profit.

The excessive short covering can result in a short squeeze.

When many traders have a poor outlook on a firm and choose to sell short the stock, a short squeeze can occur. Known as naked short selling, this strategy enables investors to sell short shares that have not been borrowed, increasing the number of shares sold short above the company’s actual share count. Suppose investor mood shifts and many investors attempt to cover their short positions simultaneously. In that case, this can create a “squeeze” on the number of shares available for purchase, leading the particular stock price to soar higher. The original brokerages that lent the shares may also opt to issue margin calls, which require the immediate return of all shares lent. This increases the number of investors attempting to cover their short positions, perhaps resulting in additional significant advances in the company’s share price.

What is a Short Squeeze?

Most stock market participants invest utilising buy-and-hold methods, looking for companies with solid long-term prospects.

However, Wall Street employs a variety of more inventive tactics for speculating on stock swings. Even if you are a buy-and-hold investor, there will be occasions when the prices of the stocks you own are influenced by the actions of other investors rather than by the company’s underlying business fundamentals. One of these events, the “short squeeze,” has the potential to send the price of a company skyrocketing overnight.

A short squeeze occurs when many investors sell short (bet against) a stock, but the stock’s price rises instead.

If an investor believes that shares of NoGood Co. are overvalued at their current price of $100, they can borrow those shares from another investor and instantly sell them to another bidder for the same price. Of all, you cannot just sell what you do not own without facing penalties; those borrowed shares must eventually be repaid. When that day arrives, the investor must purchase shares in the market to repay the lender. If the investor is correct and the share price has decreased too, say, $70, the investor will profit by $30. They borrowed $100 worth of shares, repurchased them for $70, returned them, and pocketed the difference.

If the price of NoGood’s shares increases instead, the short seller risks losing a substantial amount of money on the investment. (In contrast to price reductions, capped at zero, price increases are potentially limitless.) When the price of a stock rises swiftly, short-sellers frequently scurry to close out their positions as quickly as possible. A short squeeze occurs when many investors are simultaneously shorting a stock and attempting to exit their positions. An unexpected rise in demand for a stock’s shares might increase the price.

If, for example, NoGood Co. posted stronger-than-expected earnings and its stock price surged to $120, anxious short-sellers may rush to liquidate their bets before the share price continues to soar. This surge in demand may drive the stock to surge even higher, to $130 or $140 per share—the rapid increase in price “squeezes” short-sellers.

A few cautionary words: In general, substantially shorted stocks are heavily shorted for a reason. Possibly legitimate factors are what prompted a large number of investors to wager on a stock’s price falling. Be cautious when establishing any position in a stock that is heavily shorted. At the very least, please do some research on the company and consider why some investors are betting against it.

Additionally, if you look at the Volkswagen chart above, you’ll find that the price decreased nearly as quickly as it increased. By the end of 2008, the stock had reverted to its pre-squeeze level.

Even in the best-case situation, a short squeeze is a transient event – it is not a long-term strategy. Investing in a company with the expectation of lassoing a skyrocketing price is, at best, speculative. Not all equities with a significant level of short interest experience a squeeze.

While a short squeeze may appear thrilling, the most reliable method of becoming wealthy is locating and acquiring substantial firms and holding them for as long as feasible.

This article should give you a good idea on short squeeze and short covering, difference between short squeeze and short covering and short squeeze vs short covering