Something strange happened to the stock market this week. Retail investors — regular people like you and me — drove specific stocks to record highs by using a strategy called a “short squeeze.” So, what is a short squeeze?
Here’s everything you need to know to position yourself best for this emerging trend.
What is a short squeeze?
A short squeeze occurs when a stock rapidly jumps in value, forcing traders who had bet that its price would fall to buy it again to avoid even greater losses.
Let’s take a quick example.
Julia is bearish on XYZ Corp. She’s convinced the stock price will drop from its current $100 level. She borrows XYZ stock and sells it at $100. If the stock drops to $80, she buys it back and pockets the difference. Her profit is $20.
However, if XYZ stock rises to $120, Julia must pay the higher price to close her trade. Her loss is $20 in this scenario.
If a group of other investors wants to target Julia, they could buy XYZ stock to drive the price up. They could push it to an absurd level such as $200 or $350. Eventually, the price is driven so far up that Julia concedes defeat and closes her position. Her purchase drives the price of XYZ stock even higher. This is known as a short squeeze.
This week, retail investors on social media platform Reddit decided to coordinate short squeezes on beaten-down stocks such as Gamestop and BlackBerry. That’s why these stocks are up 382% and 90%, respectively, this week.
Are short squeezes legal?
From an average investor’s perspective, a short squeeze is perfectly legal. If you’d bought BlackBerry today expecting a short squeeze, your actions would be speculative and risky but certainly legal.
If the short squeeze pushes the value of your holdings higher and you book profits, that too is legal. We at the Motley Fool, of course, have our own opinion on this, which is shared at the end of this article.
Could my stock be a short-squeeze target?
For this strategy to be effective, the target stock needs to be heavily shorted. In other words, if the majority of a company’s outstanding shares have been bet against by hedge fund managers and Wall Street banks, the stock is ripe for a short squeeze.
BlackBerry, for instance, was ripe for a short squeeze. When Reddit users got involved on Monday, the stock surged 40%! It’s up 251% altogether from early January and is currently trading at a 10-year high.
Similarly, AMC stock surged a whopping 250% on Tuesday. More than 90% of AMC’s outstanding shares were shorted at the time, which is why this short squeeze was so immense. AMC’s Canadian rival Cineplex is also beaten down and heavily shorted at the moment.
Brookfield Property Partners is another heavily shorted stock. 46.5% of the company’s outstanding shares have an active short bet against them. Another target is Canopy Growth, which has 37.6% of its shares shorted.
Now, just because a company is heavily shorted doesn’t mean a short squeeze is imminent. Institutional investors usually do their research and have good reasons for their aggressive bets against some stocks. However, it is important for investors to understand this dynamic as it engulfs the stock market this week.
Is a short squeeze good or bad?
A short squeeze could be good or bad depending on your market position. If you’re a long-term investor who doesn’t appreciate volatility or who was looking for bargains, this is bad. If you bet against some of these stocks, this is very bad.
However, if you hold some of these stocks, you could use the short squeeze to your advantage. Booking your profits now while the stock is surging could be a good idea.
The Foolish take on short squeezes
We Fools try to be pragmatic and long-term investors. Short squeezes are the exact opposite. They’re extremely unpredictable and volatile. These strategies are also deeply speculative and relatively short term.
With that in mind, we prefer to focus on fundamentals and the long-term outlook. If one of your portfolio holdings has been swept up in this frenzy, consider booking some profits. If you’re looking to buy, take a closer look at the company’s long-term prospects and try to tune out the noise.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Vishesh Raisinghani has no position in any of the stocks mentioned. The Motley Fool recommends BlackBerry, BlackBerry, and Brookfield Property Partners LP.