A squeeze in the stock market is a situation where there is a significant and often rapid price movement in a stock, typically caused by short sellers being forced to cover their positions. This occurs when the price of a stock rises sharply, compelling short sellers to buy back shares to mitigate their losses, which in turn drives the price even higher. There are two primary types of squeezes: the short squeeze and the long squeeze.
In a short squeeze, investors who have borrowed shares to sell them at a higher price (expecting the price to drop) must buy them back as the price increases, thus driving the stock price up even further. Conversely, a long squeeze occurs when the price drops, forcing long holders to sell their positions to cut losses, further pushing the stock price down.
For long-term investors, understanding squeezes is crucial, even though they typically focus on the fundamental value of stocks rather than short-term price movements. A squeeze can cause significant volatility in the short term, leading to overvalued or undervalued stock prices that may not reflect the company’s true value. Knowing about squeezes can help long-term investors avoid buying into a stock during an artificially inflated price period or selling during an artificially deflated price period.
Effects of a Squeeze on a Stock
A squeeze can have dramatic effects on a stock’s price in the short term. During a squeeze, a stock can experience sharp, rapid price movements that are not necessarily tied to its intrinsic value. This volatility can create a misleading perception of a stock’s performance and potential.
For example, a short squeeze can lead to a significant and rapid increase in a stock’s price, causing it to appear much more valuable than it actually is based on fundamentals. This can attract more buyers, creating a cycle of rising prices disconnected from the company’s actual performance. Conversely, a long squeeze can lead to a rapid decline in a stock’s price, making it appear less valuable and potentially causing panic selling among investors who might otherwise hold onto their shares based on the company’s long-term prospects.
Different Types of Squeezes
As mentioned earlier, there are primarily two types of squeezes: short squeezes and long squeezes.
- Short Squeeze: This occurs when a heavily shorted stock’s price starts to rise, forcing short sellers to buy shares to cover their positions, which further drives up the stock price. An example of a short squeeze is what happened with GameStop (GME) in January 2021. The stock’s price skyrocketed as retail investors from forums like Reddit’s WallStreetBets started buying the stock en masse, forcing short sellers to cover their positions at much higher prices.
- Long Squeeze: This happens when the price of a stock starts to fall, causing long holders to sell their shares to prevent further losses. This selling pressure can drive the stock price down even more. While less talked about than short squeezes, long squeezes can significantly impact stocks during market downturns or in response to negative news.
What to Look for When Investing
As a buy-and-hold investor, your primary focus should be on the fundamental analysis of a company—its financial health, growth prospects, competitive position, and overall industry outlook. However, understanding the potential impact of squeezes can help you avoid making poorly timed investment decisions based on temporary price movements.
When evaluating a stock, consider the following:
- Short Interest: High short interest in a stock can indicate the potential for a short squeeze. While this can lead to temporary price spikes, it might also suggest that many investors are betting against the stock, which could be a red flag about the company’s prospects.
- Market Sentiment: Pay attention to market sentiment and news. Stocks experiencing a lot of hype or negative news might be more susceptible to squeezes.
- Price Volatility: Stocks with high volatility are more likely to experience squeezes. If a stock’s price is swinging wildly, it might be best to wait for the price to stabilize before making a long-term investment.
- Fundamentals: Always return to the fundamentals. Ensure the stock you are considering is fundamentally sound, with strong financials, good management, and a robust business model. Squeezes can distort price temporarily, but the long-term value will align with the company’s actual performance.
Prominent Examples of Squeezes
GameStop (GME) Short Squeeze (January 2021): One of the most famous examples of a short squeeze in recent history is the GameStop short squeeze. Retail investors noticed that GameStop had a very high short interest and started buying the stock en masse. This forced short sellers to cover their positions at much higher prices, causing the stock price to skyrocket from around $20 in early January 2021 to an intraday high of $483 by the end of the month. While the stock eventually came back down, it highlighted the power of collective retail investing and the dramatic effects a short squeeze can have on a stock’s price.
Volkswagen (VW) Short Squeeze (October 2008): Another notable example is the Volkswagen short squeeze in October 2008. Porsche revealed that it had acquired a significant number of VW shares, which meant that a large portion of VW’s stock was no longer available for trading. This revelation forced short sellers to cover their positions, causing the stock price to jump from around €210 to over €1,000 in a matter of days. While this price surge was short-lived, it resulted in VW briefly becoming the world’s most valuable company by market capitalization.
Should I Be Concerned About a Squeeze
Understanding what a squeeze is and its effects can help long-term investors navigate the stock market more effectively. While the primary focus should always be on a company’s fundamentals, being aware of potential short-term price distortions caused by squeezes can prevent poorly timed investment decisions. By staying informed and vigilant, you can better identify opportunities to buy quality stocks at fair prices and avoid getting caught up in temporary market frenzies. Remember, the key to successful long-term investing is patience, research, and a clear understanding of the value of the companies in which you are investing.
Happy Investing!