A short squeeze occurs when a significant number of short-sellers buy shares to cover their bets, resulting in a quick surge in the price of a company. Short-sellers borrow and sell shares with the expectation that the price would decrease, allowing them to pocket the difference between the price at which they borrowed and sold the shares and the price at which they acquire the shares later.

However, if the stock price rises dramatically in a short period of time, they may end up in losses by purchasing shares at a higher price. Short-sellers are compelled to acquire shares at a loss when this happens, and they are driven out of their position.

In January 2021, a short squeeze of the stock of the American video game retailer GameStop and other securities took place, causing major financial consequences for certain hedge funds and large losses for short-sellers. The short squeeze was initially and primarily triggered by users of the subreddit r/wallstreetbets, an Internet forum on the social news website Reddit, although a number of hedge funds also participated. Approximately 140 percent of GameStop's public float had been sold short, and the rush to buy shares to cover those positions as the price rose caused it to rise even further. At its height, on January 28, the short squeeze caused the retailer's stock price to reach a pre-market value of over US$500 per share, nearly 30 times the $17.25 valuation at the beginning of the month. The price of many other heavily shorted securities and cryptocurrencies also increased.

Why do Short Squeezes occur:

Short sellers, as previously said, take positions on equities that they predict will fall in value. A favorable news item, a product introduction, or an earnings beat that ignites the curiosity of purchasers can upend this, no matter how sound their rationale is. The stock's fortunes may flip around again, but only for a short time. If it isn't, the short seller risks incurring massive losses as their holdings near their expiration dates. They usually choose to sell out right away, even if it means taking a significant loss.

That's where the short squeeze comes in. Every buying transaction by a short-seller sends the price higher, forcing another short-seller to buy. In the cryptocurrency markets, particularly in the Bitcoin markets, short squeezes are fairly regular. High-leverage bets are used in the Bitcoin futures market, and these can be trapped or liquidated with modest price movements. As a result, short and long squeezes in the Bitcoin markets are common. If you don't want to get liquidated or caught in such moves, think about how much leverage you're utilising. A proper risk management strategy should also be implemented.

Betting on a Short Squeeze:

In order to profit from the possibility of a short squeeze, contrarian investors may purchase equities with a high level of short interest. While a rapid increase in stock price is appealing, it is not without risk. For good reason, such as a bleak future forecast, the stock may be heavily shorted.

Active traders will keep an eye on companies that are heavily shorted and wait for them to start climbing. When the price starts to gain traction, the trader jumps in to buy, hoping to profit from a possible short squeeze and a large rise higher.

Short Squeeze Trading Risks:

There are numerous examples of equities that have risen after receiving a large amount of short interest. However, there are several severely shorted equities that continue to decrease in value.

A high level of short interest does not necessarily imply that the price will climb. It indicates that a large number of people believe it will decline. Anyone buying in the hopes of a short squeeze should have other (and better) reasons to believe the stock will rise in price.

If a stock experiences a short squeeze, speculators and traders who have short positions in the stock will suffer significant losses. As the stock price rises, contrarian investors who have built up long positions in expectation of a short squeeze will benefit.

Closing Thoughts:

To summarise, a short squeeze occurs when short sellers become stuck and must cover their holdings, resulting in a significant price increase. In highly leveraged markets, short squeezes can be exceptionally volatile. Because cascading liquidations can cause a waterfall effect, price changes tend to be sharper when numerous traders and investors use high leverage. Before you start a short position, be sure you understand the ramifications of a short squeeze. You could lose a lot of money if you don't.