What is a Short Squeeze?

A short squeeze is when the price of a stock drastically increases because of the exit of short sellers. A short seller is an investor who borrows shares and believes that the value of a stock will fall. In order to close out this position, the investor will purchase those shares. If the short seller’s prediction is correct, the short seller will make a profit from the difference between the price they shorted the stock at and the price of which they buy the stock in order to close the position. If the short seller is incorrect and the price of the stock increases, the investor will lose money on that difference.

Many stocks are shorted, but in order for a short squeeze to occur, there needs to be a significant number of short sellers and enough short sellers exit their position. When a short seller wants to exit their position, they must buy orders of that share. If many try to exit, then many will begin buying shares. This increased buying volume drives the price of the stock up.

During a short squeeze, the remaining short sellers can lose a lot of money. If the stock goes up in value because of positive earnings, the short sellers will lose money. Some short sellers will buy shares to exit their position. The share price now increases even more. Then, retail traders and speculators start buying because of the stock price increasing. Now, the short sellers, who did not previously exit their position, will begin to lose more money, so they begin to buy shares and exit their position which will only further increase the stock price. This happens many times to where the stock price can nearly quadruple in a short period.

Short interest and short interest ratio are two measures to find if a stock is heavily shorted. A short interest is the total number of shares that are sold short. A short interest ratio is the total number of shorted shares divided by the stock’s average daily trading volume.

However, just because a stock has many short sellers does not mean that there will be a short squeeze. Investors short a stock because they believe a stock is overvalued and will fall in price. Those investors can sometimes be right and sometimes wrong. If they are wrong, there is potential for a short squeeze.

Some traders and investors try to find stocks that are heavily shorted in order to ride the wave of a potential short squeeze. If the short sellers are wrong, investors who own the company’s stock can see incredible returns from the short squeeze. If the short sellers are correct, existing investors can see heavy losses.

What is Liquidity Crunch?

A liquidity crunch is when an institution or economy has a lack of liquid assets that can easily be converted into cash. Business, banks, and governments have financial obligations, debts, and liabilities that they eventually must pay off. In order to pay for these debts, they must have access to cash or assets that can be quickly sold for cash. When there is a lack of liquidity, there is potential for bankruptcies and defaults.

During a liquidity crunch, there is an increase in demand for liquidity but a decrease in supply. This can occur when many institutions like banks are in need of cash, but there is no liquidity. If many institutions have this problem, it can bubble into a larger problem. For example, if a bank has a lack of liquidity, they will try to borrow cash from another bank, but if that bank also has a lack of cash, that bank will go to another. Eventually, the demand for liquidity is high, but the supply of liquidity is low.

When everyone tries to sell their assets all at once, not many are willing to buy. This can become dangerous if it impacts large private and national banks. These banks do not have access to cash, and therefore, they will not be able to make loans. Now, people cannot get loans to start and fund businesses or purchase a new home.

When Is A Good Time To Sell?

It is equally important to know when to buy a stock as to know when to sell it. Just like buying a stock, there are many factors to consider when selling a stock, such as time horizon, risk tolerance, and financial goals.

Each investor must know the time horizon for their investments. Some investors are investing to save money for a down payment on a new home to buy in five years. Others may be investing to create a retirement nest. An investor will sell a stock for cash. That cash can be used for the down payment or for retirement. For example, if a young investor does not plan on retiring for another 20-30 years, it may not be necessary to sell a stock if those savings were meant for retirement. However, if an older investor is retiring in a year or two, the investor may think it is time to sell some stock.

It is also important to understand the impact of selling on taxes. Earnings from an investment are taxed as income, but if a stock is held for less than a year, it is also subject to short term capital gains tax. Because of this, an investor should be conscious of how long they have held an investment.

Regardless, there are many reasons why an investor may choose to sell a stock. Active portfolio managers will frequently adjust their portfolio holdings. This could mean selling some assets in order to purchase new ones. Some investors have specific financial goals for their investments, such as funding a nice family vacation.

Another reason may be that a company’s fundamentals may have changed. If year over year, the sales or earnings have underperformed, an investor may exit their position. For many traders, they have specific entry and exit points for their investments. Since traders are using technical analysis, the price of which to exit is important as, for example, the stock may have broken the resistance line.

However, there is an opportunity cost associated with selling an investment. Although an investor can sell an investment for profit, there is still a chance that the investment continues to increase in value over time. If the investor had held that investment, they may have made greater profits. This is the opportunity cost – the loss of potential gain from continuing to hold an investment.