Takeaway: We explain a short squeeze in an easy-to-understand way using a current example.
Bill Ackman rode his investment in JC Penney to a double, then down to a substantial loss. After investing over $900 million to buy JCP shares at an average price of around $20 in 2010, Ackman watched as the price shot up to over $43 in early 2012 – only to see it drop to $16.50 by November. In less than one year a paper profit estimated at over $400 million had evaporated. What bailed Ackman out by year end was attributed, at least in part, to a Short Squeeze among traders who had shorted over 26% of JCP’s outstanding shares. Profit taking by short sellers drove to cover their short positions, and suddenly the stock had rebounded to over $20 a share. Bill Ackman was able to breathe a sigh of relief by year-end, as his Pershing Square fund’s position came back from the dead.
What is a Short Squeeze? Remember, a short seller has sold borrowed stock and to get out of the position has to – has to – buy the stock back in the open market. When a lot of people sell the same stock it creates Momentum, which attracts market action traders, who short even more shares. These Momentum traders will be the first to buy back their shares when the Momentum fades, and the more they buy back, the more it causes the price to rise. Soon, the short sellers get margin calls and if they don’t cover, their brokerage firms will automatically buy back shares, which sends the price still higher. If they really want to pile on, the owners of the borrowed shares instruct their brokers to pull them off margin – this is known as Calling The Shorts – which forces the short sellers to return the borrowed shares. As the supply shrinks, more short sellers have to scramble to buy shares and soon the price skyrockets out of control. This is a good time to remind you that the buyer of a stock can lose 100% of the money they invest, but for a short seller the losses are hypothetically infinite.