In order to deliver the security to the purchaser, the short seller borrows the security and then closes out its positions by returning it to the lender. Short selling can also be realized synthetically by writing a call and simultaneously buying a put, which allows bypassing the difficulties of borrowing securities, but this approach is deemed to be both expensive and risky.
The short seller hopes to sell high and rebuy lower, which will be the case if the price declines. If the stock price starts to rise rapidly, short sellers, whose positions are loosing, may be forced to liquidate and cover their positions by buying the stock. h is additional buying pressure on prices leads to a further rise in the price and potentially to the need of additional short covering.
The short squeeze illustrates the dangers associated with a short position, which can generate unlimited losses while in a long position the losses are limited to the current price of the asset (at worse, the price will end at zero). In general, the short squeeze is more frequent than the opposite situation, the long squeeze, where buyers have to sell out rapidly their long positions.
Short squeezes are favoured by automatic systems that trigger stop-loss orders. Small caps securities are known to be particularly exposed to the short squeeze risks. The inability of short sellers to maintain their positions due to the risk of short squeeze appears as a significant limit to arbitrage overvalued stocks.
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| Short Squeeze |
