Bear Squeeze: What It Is, How It Works, and Example

What Is a Bear Squeeze?

The stock market can sometimes resemble a high-stakes game where the line between predator and prey is all too thin. One of the most dramatic versions of this is when there’s a bear squeeze, when those doing the hunting in a seemingly bullish market become the hunted as the market goes back up—fast.

In 2021, video game retailer GameStop’s stock soared over 1,600% in just a few weeks, largely fueled by a massive bear squeeze that surprised major investors on Wall Street.

A bear squeeze happens when a stock’s price rises sharply, forcing short sellers—investors betting on a price decline—to race against one another to buy back shares at higher prices to cut their losses. This buying pressure further drives up the stock price, reinforcing the cycle.

While often associated with meme stocks and retail investor zeal, bear squeezes can occur in any market where short selling is prevalent.

Below, we’ll explore how a bear squeeze works, examine its causes and historical examples, and tell you what to look out for lest you’re baited unwittingly into the next bear squeeze.

Understanding a Bear Squeeze

A bear squeeze is a sudden change in market conditions that forces traders attempting to profit from price declines to buy back underlying assets at a higher price than they sold for when entering the trade. As the term implies, traders get squeezed out of their positions, usually at a loss.

A bear squeeze can be an intentional event precipitated by financial authorities, such as central banks, or it could be a byproduct of market psychology where market makers, taking advantage of waning selling pressure, intensify their buying efforts to push that security’s price higher. A bear squeeze engineered by a central bank is done with the intent of propping up the price of a currency in the foreign exchange market. This is accomplished by buying large amounts of that currency, essentially reducing the available supply in the market, which results in that currency appreciating sharply and setting off a bear squeeze.

While it is more common in the currency markets, a bear squeeze can happen in any market where the price of an asset is suddenly driven up. Sellers holding short positions in currencies or other assets must buy at the prevailing market price to cover their position—which, given the speed of the move, often results in significant losses.

A bear squeeze is often associated with a short squeeze, a phrase that is more popular with the average investor. A short squeeze is a situation in which a heavily shorted security, such as a stock or commodity, moves sharply higher, forcing more short sellers to close out their short positions, adding to the upward pressure on that security’s price. Market makers who can corner the market can initiate a bear squeeze if they deem the circumstances to be ripe for such an event.

In the equity market, a bear squeeze is generally triggered by a positive development that suggests the stock may be turning around. Although the turnaround in the stock’s fortunes may be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out, even if it means taking a substantial loss.

If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if a stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price increases.

Bear Squeeze vs. Short Squeeze

Often confused, there’s a subtle difference between the two:

1. Short Squeeze: This occurs when a heavily shorted stock undergoes a sudden price increase, forcing short sellers to buy shares to cover their positions. As the price rises, more short sellers rush to exit their positions, further driving up the stock price. It typically happens when a stock with a large short interest unexpectedly moves upward, often due to positive news or momentum.
2. Bear Squeeze: A bear squeeze is broader and refers to a situation where bearish traders (including those holding short positions or other downside bets) are forced to exit their positions due to an unexpected and sharp upward movement in prices. A bear squeeze can involve short sellers and traders using options or other bearish strategies. The term can be applied to a range of markets beyond just stocks.
   

Profiting From a Bear Squeeze

Contrarians look for assets that have heavy short interest—the number of shares that have been sold short but have not yet been covered or closed out—to see if there’s a chance of a short squeeze happening. They may then accumulate long positions in heavily shorted assets.

The risk-reward payoff for a heavily shorted asset trading in the low single digits is favorable for contrarians with long positions. Their risk is limited to its price, while the profit potential is unlimited. This risk is opposed to the risk-reward profile of the short seller, who, theoretically, could face unlimited losses if the stock spikes higher on a short squeeze.

Example of a Bear Squeeze

Consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials. There’s considerable skepticism among investors about whether this drug candidate will work and, as a result, five million of Medico’s 25 million outstanding shares have been shorted. Short interest on Medico goes up to 20%. With an average daily trading volume of 1 million shares, the short interest ratio is five. This essentially means that it would take five days for short sellers to buy back all Medico shares that have been sold short.

Assume that, because of the massive short interest, Medico had declined from $15 a few months ago to $5 shortly before the release of the clinical trial results. Then, there’s an announcement that Medico’s drug candidate had far better results than expected. Medico’s shares go up significantly on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions. This leads to further buying and further appreciation of Medico’s stock.

Meme Stocks and Bear Squeezes

In January 2021, the financial world watched as shares of GameStop (GME), a struggling brick-and-mortar video game retailer, soared from around $20 to nearly $500 per share in a matter of weeks. This unprecedented surge wasn’t driven by a sudden turnaround in the company’s fortunes, but from a storm of factors that led to a series of dramatic bear squeezes.

At the heart of the GameStop saga was a clash between retail investors, coordinating largely through the Reddit forum r/WallStreetBets, and institutional investors who had heavily shorted the stock. Short sellers had borrowed and sold millions of GameStop shares, betting the price would fall. However, when a surge of retail buying pushed the stock price up, these short sellers found themselves in an increasingly precarious position.

As GameStop’s price climbed, short sellers faced mounting losses and margin calls, forcing them to buy back shares to close their positions. This buying pressure, combined with the enthusiasm of retail investors and fear of missing out (FOMO) from other market participants, created a feedback loop that sent the stock price soaring. This textbook bear squeeze was amplified by options activity and widespread media coverage, turning GameStop into wider news—which then amplified things still further.

The GameStop event wasn’t an isolated incident. Other heavily shorted stocks, dubbed “meme stocks” due to the use of social media, underwent similar, if less dramatic, squeezes. Companies like AMC Entertainment (AMC) had their share prices surge as retail investors piled in, often citing a mix of profit potential and a desire to challenge Wall Street norms.

While outliers, these did show how modern bear squeezes could be due to the following:

• Accessibility of trading: Commission-free trading apps like Robinhood lowered barriers to entry for retail investors, allowing them to act quickly.
• Options impact: Retail investors’ widespread use of call options created additional upward pressure on stock prices through a mechanism known as a “gamma squeeze.”
• Short interest transparency: Publicly available data on short interest helped investors identify potential squeeze candidates.
• Social media’s role: Platforms like Reddit enabled rapid information sharing and coordination among retail investors, making it easier to identify and target heavily shorted stocks.

The Bottom Line

Bear squeezes occur when a rapid increase in a stock’s price forces short sellers to buy back shares to cover their positions, further driving up the price in a self-reinforcing cycle. While bear squeezes can create prospects for quick profits, they also carry substantial risks and can lead to extreme market volatility.

Investors should approach potential bear squeeze situations with caution, understanding that these events are often short-lived and can reverse quickly. While the allure of rapid gains can be tempting, it’s very often much better to maintain a balanced, well-researched investment strategy rather than chasing the next potential squeeze.