A short squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and an excess of demand for the stock.
By definition, a short squeeze is the position in the stock prices that prompts an increase which in return accelerates buying of stocks amongst short sellers. To close short positions, the short sellers buy stocks which reduce or eliminate their losses. This leads to a further increase in the prices of the stock, which invites a larger number of short sellers to save their positions.
Short Squeeze: How does it work?
The expected fall in the prices of the stock leads to a short sale of the stocks in the market. The investor basically borrows stocks/shares of a particular company from a legal broker. The shares are then sold at the market price rate. The investor does this in the hope of buying back the shares at a much declined rate in the long-term. Therefore, unlike the traditional classic buy first/then sell method, the investor sells high and buys at a lower price.
Short squeeze would occur when the stocks do not decline as predicted.
Company ABC sells stock at $50. The price goes up to $55 instead of going down. It keeps on going higher. As an investor who shorted the stocks, this is bad news for you. Now you need to now cover your position, as well as eliminate the losses. Therefore, you buy Company ABC’s stocks and like you, many others do the same, thus increasing the buying pressure on the stock. This leads to increase in the already increased price.
Short squeeze: Why does it matter?
It has been deemed as a smart way by finance advisors and professionals to hedge a portfolio enjoy the declined market and exploit the knowledge of a certain stock. At the same time, it is an uncertain investment.
The concept of short squeeze is popular in small-cap stocks; however, they can occur in any stock. To take advantage of the short squeeze, the short term traders should enter the selling market if there are enough buyers. Furthermore, there is no guarantee that the stock will trade at higher, or move at lower. In an absolute market, the investor would want to trade in the direction of the (at the time) trend.
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