Short-squeezes have dominated the markets over the past few months as meme stocks continue to take over, but what exactly does it mean?
Short-squeezes used to be an unusual occurrence on Wall Street. However, with the growing meme stock craze amongst heavily shorted companies, they have become more commonplace.
So, what exactly is a short-squeeze?
A short-squeeze happens when a stock price, or other asset, rises rapidly all of a sudden. Most importantly, for a security to be classified as being in a short-squeeze it must have an abnormal amount of short-sellers holding positions in the stock.
What is short selling?
Short selling offers people a way to profit when the price of a stock declines. These investors borrow the stock when it is high, predicting that it will fall in the future, and then sell those shares. Then when the stock drops, they buy it back at the lower price and return it to who they borrowed it from.
Sellers make a profit from the difference in the price between when they sold the stock and when they bought it back.
Read more on what it means: Investing Terms: What Is Short Selling?
When short sellers pick a stock to bet against, but it backfires and the stock rises unexpectedly, a short-squeeze can begin when those traders decide to cut their losses and exit their positions.
The stock can jump dramatically for a few reasons. For example, an earnings beat, a new product announcement, or any other positive news from a company, can result in more investors buying the stock.
Sometimes short sellers have to sell their positions at a loss because short positions have an expiration date. So when a stock jumps suddenly, they may have to sell fast to limit the damage. When panicked sellers buy back at the higher price, this also pushes the stock price higher.
When investors see prices skyrocketing, many are also attracted to buying the stock in the hopes of making a quick profit. The combination of both results in a rapid rise.
Tesla was a heavily shorted stock
In 2020, Tesla (NASDAQ: TSLA) was one of the most-shorted stocks on the U.S. market, with over 18% of its outstanding shares sold short. However, the EV maker gained many fans who believed in the company’s innovation who then invested in Tesla shares. When this happened, short-sellers lost around $8 billion. However, in March 2020, they made $50 billion when Tesla stock dropped.
Short-squeezes during the meme stock craze
Short-squeezes that have been happening on the market this year have been unprecedented. Retail investors using Reddit forum r/WallStreetBets have intentionally invested in stocks that have a high level of short interest knowing that short-sellers, many of which are wealthy hedge funds, will have to sell at a loss. These stocks have become known as meme stocks.
These groups of traders believe that short selling is wrong and that people shouldn’t be profiting from a company failing. Reddit investors also say that they want to help these companies, and with a higher market cap, some firms are benefiting from the trend. Others are just simply following the trend to make a quick buck and if it means sticking it to rich investors, that’s just a plus.
Should I invest during a short-squeeze?
Remember, investing in a stock that is going through a short-squeeze is very risky as you never know when others are going to take profits, which will result in the stock falling suddenly. If a stock is only jumping because people are being told to buy it on social media, or because short-sellers are covering their losses, these are not good reasons to invest in a company long-term.
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