Let’s start with a famous example of a short squeeze. Everybody knows about the furore concerning GameStop Corp. To remind you, GameStop is a listed company that sells video games and consumer electronics.
Based in Texas, it is the world’s largest video game retailer with over 4,800 stores. However, sales took a downturn due to increasing sales of online games.
Following a failed private equity sale, sales nosedived by 27% in early 2019; the company posted a loss of $670 million against a $34.7 million profit the previous year. When the pandemic lockdown forced GameStop to close many stores, the business struggled to survive.
Unsurprisingly, many institutional investors short sold the stock to such an extent that over 140% of public shares were shorted.
However, several traders considered the stock undervalued and invested significantly. Many Reddit users piled in, triggering a short squeeze and elevating the share price substantially.
Over two weeks in January 2021, the price increased by a staggering 1,500%. Many retail traders made significant profits though hedge funds that had shorted the shares lost $6 billion.
So what exactly is a short squeeze?
When institutional short sellers purchase large volumes of stock to cover their positions, the stock price increases; this leads to more short sellers similarly covering their positions by purchasing the stock, leading to further price rises.
The result is cascading purchases and ever-increasing prices. In a nutshell:
- The short is a bet that the targeted company’s share price will fall. The investor borrows the stock from large investors such as pension funds, then sells it intending to repurchase it at a lower price to return to the original owner. The short seller pays interest on the loan.
- The squeeze happens when the stock price rises rather than falls. It is usually driven by retailer traders purchasing the stock to close their short positions, thus forcing the short seller to buy more stock to cover their losses, thus triggering the short squeeze.
Meme stocks are shares that have achieved a large following on social media platforms such as Reddit. GameStop is probably the first widely recognised meme stock. Such online communities can significantly affect share prices and trigger short squeezes on heavily shorted stocks.
With good timing, members of meme stock communities can raise and maintain stock prices above their fundamental values and thus make significant profits. So how do you find meme stocks with short squeeze potential in which to invest?
Finding short squeeze stocks
There are several factors to consider when identifying stocks with short squeeze potential. These include the time to cover ratio and the shorted percentage of traded stock.
- Time to cover ratio – The time to cover ratio is the ratio between the number of shares that have been shorted and the average daily volume. Stocks with short squeeze potential might be likely to have been heavily shorted compared to their trading volumes. For instance, if a stock has 100,000 shorted shares and, on average, 10,000 are traded a day, it would take ten days to cover all the short positions on average volumes. Short-sellers tend to target stock with high time to cover ratios; however, a high time to cover ratio isn’t necessarily a good indicator of a potential squeeze. It is just one factor to consider.
- Shorted stock as a percentage of traded stock – If the shorted stock represents a high percentage of traded stock, it is another possible squeeze indicator. But the question is, what is a high percentage? While there is no absolute answer, people generally consider 20% significantly high, though even 10% is worth noting.
- Daily charts – checking daily average moving charts to determine where the stock has traded for a given period, say 50 days, will identify any price peaks that occur.
- News and social media – short squeezes are often triggered by news announcements, so always follow any information about your stocks avidly. Social media can also be a good data source, especially meme groups such as Reddit, but of course, it’s easy to be misled.
Timing – the essential element in a successful short squeeze
Timing is crucial. If you get the timing right, a short squeeze can generate significant profits.
However, timing a peak is not always possible – there is a substantial risk of getting it wrong. So make sure you get out on time – while many amateur traders made handsome returns on GameStop, others were less fortunate and were left holding stock after the price fell.