A Visual Explanation To Short Squeezes

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Today, we will dive into “A Visual Explanation To Short Squeezes" 👇

The year of 2021 was the one filled with market anomalies, but the one that took the market by surprise was the Gamestop short squeeze that was driven by a rally to take on short sellers from the WallStreetBets subreddit. Although short squeezes may seem simple, they are a bit complex when you look under the hood. This post is meant to graphically show how short squeezes happen as well providing the mechanics on why they occur.

The mechanics behind longs and shorts

To understand short squeezes we have to understand the mechanics of longs and shorts. Most investors usually invest using by going long on a stock. This is when an investor purchases the stock and then hopefully sells it a higher price in the future. A short seller is when an individual wants to bet against a stock hoping that it falls. But instead of selling the stock at a higher price for a profit, they want to buy the stock back at a lower price, we’ll get more into the short positions if this seems confusing now.

Short sellers have all sort of motives, some short sellers are actively trying to take down companies (see activist short sellers), some do it because they think the stock is overvalued, and others may do it to hedge out their portfolio (see long short strategy).

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We won’t dive too deep on longs and shorts but below covers the relevant material to understand them. Here is a simpleprocess for entering longs and shorts.

To reiterate the most important part of these positions are

We can see that an investor that goes long has to buy to get into the position, and sell, to get out of the position. And a short seller has to sell to get into a position and buy to get out. (The technical terms for the short seller are selling short,and buying to cover).

Price Discovery Analysis

To analyze a stock’s price we will use the price discovery method. We’ll start with a standard supply and demand curve for modeling stock prices. Although this explanation works in theory and the mechanics behind this model are applicable in real life, it is technically impossible to know the future movement of supply and demand curves. To do so would require one to know all of current and potential investors’ future decisions, which are hard to predict.

In this simple representation where supply stays constant, an increase in demand leads to a higher price and a decrease in demand leads to a lower price.

Even though keeping supply constant is not technically accurate, it provides for a better visual explanation later**.** In general, changes in supply would mean that there are less or more sellers in the market.

Orderbook analysis

To analyze movements in the stock we will examine the orderbook, which displays the type of order and the quantity of orders for a certain price. It shows how prices change with incoming bids and asks. The bids are the orders to buy the stock and the and the asks are the orders to sell the stock. In stock trading there is usually a slight difference between bids and asks (the spread), we can see that the spread between the highest bid ($125.82) and the lowest ask ($126.80). A transaction doesn’t occur until bid and ask agree upon a price (which would look like an order on each side of the price). So in this case if you were looking to buy the stock you would have to meet the lowest ask which is $126.80.

This is a sample orderbook that I found from TradingView. A live orderbook would be filled with a number of bids and asks in each column. Orderbook information can be found in your brokerage account if you have access to level II market data. I like to think of orderbook dynamics as forces moving against each other. For example if there are more buyers than sellers then, the green vector will be bigger than the red vector which will push the price up. If there are more sellers than buyers then the red vector will be bigger, which will push prices down.

The following is a different visual representation of bids and asks that shows volume. Looking at the bids (green) we can see that there is a preference to buy the stock at a lower price. As for the asks (red) the majority of sellers are looking to sell the stock at higher price.

Gamestop Example

Now let’s get into the mechanics behind a short squeeze, and in this case we will look at the Gamestop short squeeze which garnered a great deal of attention recently.

In this example we will start with 7 short positions. Each short position comes from a different short seller. We can see on the aggregate that the stock is downward trending for the most part. This works in the best interest of the short seller who sells the stock and hopes to buy it back at a cheaper price, and they will profit from the difference. We can also see that the short sell positions are represented with the green profit bar below the price they entered in at.

Now let’s talk about how the short seller’s position may go awry. If the stock price increases which isn’t what the short seller wants and they begin to lose money, then are going to want to exit their position. Keep in mind that exiting a short position requires buying the stock back. This is the bug in short selling, its this little feature that creates a short squeeze. Let’s say a short seller wants out, they’ll buy the stock back, but also going back to our price discovery method, buying a stock increases the demand, which increases the price.

This is where the squeeze occurs, each short seller exits their position which pushes the price up, causing the next short seller to lose money.

The timeline of trades would look like this.

Graphically it would look like this with the price on left side and the supply and demand on the right side. We can see that when the short seller buys the stock back they increase the demand which increases price.

We can see that when this all starts to happen the price can dramatically increase.

Why Short Squeezes happen

The main factor that contributes to short squeezes is that a short seller who is looking to exit their position has to buy the stock which pushes the price up, and that hits the next seller and so forth.

Some short squeezes may occur naturally, although they rarely do. This can happen if a stock posts good quarterly results or makes a positive announcement. That increase in price could trigger a short squeeze. For example when famed activist short seller Citron Research ran by Andrew Left switched his short position on Tesla Inc, that created a short squeeze(see here).

If short sellers succeed and push the price of the stock down then there is a risk that a short squeeze may occur. Contrarian investors which are investors that take go against the grain approach in investing may bet on a company who’s price is falling. Their purchase may cause a short squeeze, and its common for contrarian investors to try and garner public support which would rally investors. Value investors who constantly ask “is this stock overvalued or undervalued?” may see a stock that has been falling because of short sellers and say that its undervalued and buy up a bunch of shares causing a short squeeze.

But the most famous short squeezes that are studied come from market manipulation. This occurs when a trader or group of traders realize that with a large enough buy order will push the price up triggering a short squeeze.

Although it feels like short squeezes have been happening a lot with talks about meme stocks, they actually don’t occur too often. I would assume that as markets calm when our lives fully revert back to normal (or whatever normal is post-pandemic) there will be less of these events.