A short squeeze occurs when an event or condition causes the price of an asset that has been heavily shorted to rise rapidly. Traders with short positions are then forced to increase the equity in their account to maintain the rising margin of the trade, otherwise, they are forced to close the trade and buy back the asset at a loss.
Both the combination of new traders entering long positions and short sellers attempting to buy back the security to close their position contributes to the skyrocketing price effect characteristic of a short squeeze.
The GameStop (GME) short squeeze is a notorious example from recent history. In January 2021, about 140% of GME’s publicly available shares had been shorted, mainly by hedge funds and other large financial institutions, who leveraged their positions even further than levels afforded by their large coffers with margin because of the widespread belief that GME’s price would continue to fall.
Retail traders on the subreddit r/wallstreetbets, a popular message board, took notice and organized a massive buy-in. These small-net worth traders did not have the buying power to short GME to the extent larger financial institutions did, and many of them saw the widespread shorting as unfair. These retail traders encouraged more to buy in on GME and raise the stock’s price, threatening the short positions of the large financial institutions.
Because the shorters were trading on margin, they were required to add more money to their accounts in order to maintain their shorts and not be forced to close their positions at a loss. However, small-networth traders online had since spread the short squeeze beyond Reddit and across the rest of the internet while also encouraging one another to hold their now lucrative positions and continue squeezing the big players.
By January 28, 2021, GME’s stock price climbed to over $500, up from $17.25 at the beginning of the month, and the hedge funds that shorted GME were forced to continue increasing the amount of money on margin. By the end of the month, those hedge funds and other short-sellers had lost over $6b on the stock. Several of the institutions declared bankruptcy, and GME’s stock price still hovered at $100 a year later.