What it is:
A short squeeze is a situation in which a stock's price increase triggers a rush of buying activity among short sellers. Short sellers must buy stock to close out their short positions and cut their losses, which results in a further increase in stock prices, which compel still more short sellers to cover their positions.
How it works (Example):
A short sale reverses the normal buy first/sell second sequence as a way to from an anticipated future fall in price. An investor borrows of Company XYZ from a broker and sells them at the market price. The investor hopes to buy back the at a lower price in the future, thereby "covering" the position by giving back the broker his . Instead of the traditional "buy low/sell high", an investor seeks to "sell high/buy low".
A short squeeze occurs when the stock's price doesn't decline as anticipated.
For example, let's say you sell short Company XYZ stock at $20. But, instead of the price going down, it goes up to $25 and appears to be going higher. Now you're in trouble. You need to cover your position and limit your losses. You decide to buy Company XYZas soon as possible--you and everybody else who shorted the stock. This generates tremendous buying pressure on the stock, and the short sellers rushing to cover their positions only escalate the price increase.
Why it Matters:
Short selling can be a smart way to hedge a portfolio, take advantage of a down market, or capitalize on knowledge of a certain stock. However, selling short is a very aggressive and risky investment. After all, with a regular stock purchase, an investor can only lose the original investment as the stock falls to zero. But in theory, a stock's upside price potential is unlimited. The investor can end up on the hook for more than his original investment.
Short squeezes occur more often in small-cap stocks with small floats, but they can occur with any stock. Investors should pay attention to the short interest ratio of a particular stock and the number of sold short relative to the float--those with high short-interest ratios are often more susceptible to a squeeze.
Click here to learn how to Profit From the "Short Squeeze."