As we have seen, you can borrow shares that you don't have so that you can sell in the market and open a short position. While you have the short position open, you owe those shares to the entity that you borrowed them from (usually some sort of pension or mutual fund that does securities lending). Assuming there is no forced buy-in, you close out the position by eventually (when you decide) buying back to cover, thereby returning the shares to the original lender, netting you either a profit (if the shares declined) or a loss (if the shares rose).
Let's assume for a moment that there is a public company with a very small float (number of shares that are tradeable). This company's prospects at this time are negative so a lot of investors sell shares short and they do it in such numbers that a large percentage of the float is at one point sold short. At this point it is important to remember that all those shares that are sold short will have to eventually be bought back and returned so all those shares are potential buys waiting to happen (i.e. potential demand for shares).
Now what would happen if the company's prospects start to get better and the shares start to rise? Those investors who sold shares short will be faced with losing positions as the price goes up. As the shares start going higher and higher some of those short sellers will start hitting their stop losses (their pre-determined point at which they will close out the position at a loss to prevent further losses) and so they would start closing out their short positions.
The fact that some short sellers started closing out their positions only adds to the demand for shares (since they close out a short position by buying back shares), thereby pushing the price even higher. As those prices get higher, more short sellers will give up and cover, adding to the buying pressure. Later on, some short sellers will be forced to cover as they receive margin calls from their broker (if they shorted on margin) and even more buying pressure will push the price even higher.
As you can see, this process can very easily spiral out of control since it's a process that feeds on itself. Especially where the shares sold short are a large percentage of the float, there can be a situation where the demand for shares overwhelms the supply of remaining shares so much that the price surges higher because short sellers are being forced to cover at higher and higher prices. In other words, they are being squeezed and because of this, this process is informally known as a short squeeze.
In practical terms for us as traders or investors, we should know the following about short squeezes:
- Stocks that have a small float (for example compared to daily trading volume) are more susceptible to short squeezes than stocks with a large float, since there will be a larger supply of shares readily available to meet the short sellers' demand for stock during a potential squeeze.
- Stocks that are already heavily shorted can potentially be a part of a short squeeze if price starts going higher. The number of shares sold short is available from your financial data service, albeit on a delayed basis and only reported on twice a month.
- In fact many savvy traders identify the conditions for short squeezes to play them from the other side, being long the stock that is undergoing a short squeeze. These positions if identified and acted upon in a timely manner can be very profitable and usually in a very short time.
- Because of this, in general you should not short shares of a company that has a small float or that is already heavily shorted (as a percentage of the float).
- As a general rule, the timeframe for short positions should be much smaller than for long positions precisely to avoid these types of situations and if you do short, always do so with a pre-defined stop loss level to limit losses if the position moves against you.