https://www.ft.com/__origami/service/image/v2/images/raw/https%3A%2F%2Fd1e00ek4ebabms.cloudfront.net%2Fproduction%2F78111172-36f2-4873-b267-d2cd4dc5478d.png?dpr=1&fit=scale-down&quality=highest&source=next&width=700Traditionally, investing for the future involves buying stocks at a low price and hopefully selling them many years down the road for a much higher price, thus pocketing the difference.

But, the stock market is a two-way street, and stocks have just as much of a propensity to move lower as they do higher. Even though the stock market has historically returned close to 8% per year, it doesn’t mean you can throw a dart and land a winner every time.

Investors who want to take advantage of those downward movements in stock prices can consider short-selling a stock. In short-selling, your brokerage firm will sell shares of the stock in question and credit your account with the proceeds. At some point in the future, you’ll need to purchase an equal number of shares of the stock in order to close the position. If the stock price moves lower, you make money. If the opposite occurs and the stock price rises, you lose money.

The danger of betting against a stock or crypto via short-selling is that stock price declines are capped at 100%, because a stock price can’t go below $0. However, if a stock doubles you’ll lose your initial investment. If it more than doubles, then you’ll actually owe money! Your losses are limitless, while your profits are capped when short-selling. The opposite is true of buying a stock, where your losses are capped at 100% and your profits are limitless.

Yet there’s another built-in concern to short-selling that some pessimists fail to account for: the dreaded short squeeze.

What is a short squeeze?
A short squeeze generally occurs when there is positive news on a stock, or simply an increased demand for shares of a stock, which causes the price of the stock to rapidly rise. Understanding that a rising stock is bad news for short-sellers since it means they’re losing money, they’ll try to exit their position (what’s known as “buy to cover” their short-sale position).

However, in a short squeeze, it may not be easy for short-sellers to cover their shares. Furthermore, buying to cover only pushes the stock price up even higher, exacerbating the situation (and losses) for remaining short-sellers. Although a short squeeze can occur while a short-seller is in the black on their position, short squeezes are most often associated with short-sellers losing money.

How do you determine if a stock is a short squeeze candidate?
To determine whether or not a stock is a candidate for a short squeeze, investors would be wise to consider two metrics.

The first is a stocks’ short shares as a percentage of float, or the amount of shares currently held by short-sellers as a percentage of available, tradable shares. Generally speaking, the higher the short percentage relative to float, the higher the possibility of a short squeeze occurring.

 

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