A situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock. A short squeeze implies that short sellers are being squeezed out of their short positions, usually at a loss. A short squeeze is generally triggered by a positive development that suggests the stock may be embarking on a turnaround.
If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. If enough short sellers buy back the stock, the price is pushed even higher. Two measures useful in identifying stocks at risk of a short squeeze are a short interest and b short-interest ratio. As an example, consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials as a treatment for skin cancer.
There is considerable skepticism among investors about whether this drug candidate will actually work, and as a result, 5 million Medico shares have been sold short of its 25 million shares outstanding. The SIR means that it would take 5 days for short sellers to buy back all Medico shares that have been sold short.
A short squeeze in Medico is now on, and can drive it much higher due to massive buying pressure. Contrarian investors look for stocks with heavy short interest specifically because of a short-squeeze risk. These investors may accumulate long positions in a heavily shorted stock if they believe its chances of success are significantly higher than believed by those who are bearish on it.
The risk-reward payoff for a heavily shorted stock trading in the low single digits is quite favorable for contrarian investors with long positions. Their risk is limited to the price paid for it, while the profit potential is unlimited. This is diametrically opposite to the risk-reward profile of the short seller, who bears the risk of theoretically unlimited losses if the stock spikes higher on a short squeeze.
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