A short squeeze is one of the most spectacular, and, for some people, dangerous things in finance. In order to see what it is and why it happens, we will first discuss the practice of selling short. We will then discuss the conditions under which a short squeeze can occur. Finally, a stunning recent example will be discussed.

A short squeeze can occur in any physical security. This includes things like stocks and bonds. Of these physical securities, only a finite amount exists. A company may have 1 million shares, and they cannot be created by trading. This contrasts with options, which are contracts that can be created. In principle, it is not possible to sell a physical thing you don't have, as you cannot deliver the asset - let us for the moment assume it is a share. What you can do is agree with the owner of the shares to borrow them, giving the owner of the physical shares a fee and the pledge to return them if asked. You also pay the owner a small fee. You now own the shares, and can sell them in the market. If the shares drop, you can buy them back at a lower price, and give them back to the owner, and you stop paying the fee. The key here is that at any time, the lender can ask you to return the shares, and you will have to do so, buying them back at the current level.

The worst situation that can happen when you are short is that the stock goes up. You will then have to buy back at a higher level. The danger here is that being short means you cannot sit and wait for the share price to return. First of all, there is the perpetual risk of having to deliver the shares to the borrower if asked. Secondly, a share can rise to very high levels. Being long, you can at most lose the investment. Being short, the potential loss is unlimited. Hence, being short, a stock can always rise to a level at which you are forced to liquidate - time is working against you and you cannot just "sit and wait".

For a short squeeze to occur, there have to be two factors. Firstly, the stock has to rise, so short sellers are facing losses. Secondly, it must be difficult to buy the security. This may, for instance, happen when the amount of shares that are traded is not large because the bulk of the shares is held by big investors who won't sell. In this case, the following may happen. One of the people who is short just cannot bear the losses or the risk anymore and is forced to liquidate. As mentioned, this is not easy. There are few shares available, and buying drives up the price. This price rise causes losses in other market participants, who also see the liquidity in the share drying up. They have large losses, in fact, they may be so large that they too are forced to either post capital to cover these losses, or to close the position. If one of them decides to close the position, the stock price rises further and losses mount for the other short sellers. The resulting spiral can drive prices to insane levels - a short squeeze can easily quadruple the value of a share or worse. This leads to losses far worse than what could happen in the case of a bankruptcy in case you are long. This is why a short squeeze is so dangerous: there is no limit to the loss, hence, weathering the storm may not be an option. Hence, a large short position in a relatively illiquid share is dangerous.

Recently, there was a massive short squeeze in Volkswagen. Volkswagen is a German car manufacturer. Porsche owns around 43% of the shares, the German state of Lower Saxony owns another 20%. Volkswagen is a fairly large part of the Xetra DAX index. This means people building a fund that tracks the index will have to buy the shares in order to do so. This accounts for a few percent of the shares. Hence, about 65% -70% of the shares is accounted for. Volkswagen was a popular short for the following reasons:

  1. Car makers were expected to be hammered by the recession.
  2. There is a strategy in which the preferential shares of Volkswagen are bought and the regular shares sold. Logically, these shares should be worth almost the same; the main difference is the prefs do not carry voting rights. Note that these shares are not fungible: if you short-sold the share, delivering the pref to the lender won't do.
On Sunday October 26th 2008, Porsche announced they had options in different German banks that would allow them to buy another 31.5% of Volkswagen. We can safely assume the banks hedged these options by buying shares of Volkswagen, to the tune of exactly 31.5% (The fact that these options were cash-settled offers another possibility for mischief I won't go into). This means about 95-100% of Volkswagen shares are accounted for. The hedge funds shorting were short about 13% of Volkswagen in total. Porsche also remarked they were doing this announcement to give short sellers the opportunity to close their position in an orderly fashion.

Monday morning, Volkswagen spiked from about 250 to over 1000 euros. At that price, Volkswagen was theoretically the largest company in the world. The hedge funds were left with about 40 billion euros in (theoretical) losses. There was almost no liquidity. People selling the shares at 1000 made a killing. The DAX also spiked up. This situation simmered for about a week until two things happened:

  1. In an unprecedented move, the weight of Volkswagen in the DAX was reduced. This means that index trackers had to sell Volkswagen at that very high price point, locking in a considerable profit for their investors.
  2. Porsche announced they would sell 5% of their holdings.
Both of these actions released shares. Of course, Porsche made a killing on this, far more than on the sale of their cars. In fact, many of their customers are the very hedge fund managers that were hit; Porsche found a more direct way than selling cars to get their money. People investing in the DAX also made a lot of money. Because the end of the squeeze caused a price drop, the hedge funds didn't lose the full 40 billion, although the losses are of that magnitude.

In summary, a short squeeze is the sudden rise of the share price due to people being forced to liquidate their short positions. This is particularly likely in relatively illiquid shares with a large amount of short selling. The results can be devastating, as the loss can be unlimited.

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