“Short Squeeze” vs. “Short Covering”: A Short Position Break-Down

By: Montana Timpson

Retail investors’ “revolution on Wall Street” has GameStop (GME) short sellers in a tailspin, amassing an estimated US$19 billion in shorting losses to date.

Reddit forum members banded together to help drive up GameStop stock by more than 1,500% over the past month alone, following rallied cries to “beat the system.” Goldman Sachs says the stock market is undergoing its biggest short squeeze in 25 years — and that hedge funds are dumping stock exposure at the fastest rate since 2009.

To better understand the unprecedented phenomena surrounding the 2021 GameStop short squeeze, one must note the basis of both the “short squeeze” and “short coverings.”

A “short squeeze,” by definition, is a situation in which a security’s price increases significantly, causing short sellers to close their short positions. A short squeeze involves a rush of buying activity among short sellers due to an increase in the price of a security, and, in turn, that increase in the security price causes short sellers to buy it back to close out their short positions and book their losses. This market activity causes a further increase in the security’s price, which forces more short sellers to cover their short positions in an act known as “short covering,” as was the case with the GameStop surges.

“Short coverings,” in full, involve the buying back of a security to close out an open short position. To close out a short position, traders and investors purchase the same number of shares in the security they sold short. A short position will be profitable if it is covered at a lower price than the initial transaction; it will incur a loss if it is covered at a higher price than the initial transaction.

Recent Ortex figures suggested that investors who had bet that the GameStop share price would fall had been massively squeezed, with short losses topping $10 billion on Wednesday, alone, when GameStop soared 135%. These numbers, alongside other astonishing recent stats, highlight the cyclical nature of a short squeeze, as the squeeze pressures bearish short sellers to bite again in order to forestall even greater losses.

For more professional trading terminology, guides and resources, visit Lightspeed’s Active Trading Blog and register now for our next live webinar.

The author holds no positions in any of the stocks mentioned.

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