Short sellers borrow stock from a broker and sell it at market price, hoping to buy the stock back at a lower price in order to pocket the difference between their sell and buy price. Since short sellers typically make short-term investments, they are highly sensitive to rapid upswings in the share price of a company, according to Paul J. Irvine of the University of Georgia. Unscrupulous investors can illegally take advantage of this fact in order to create a short squeeze.
A short squeeze naturally occurs when the share price of a company increases rapidly due to high investor demand for shares. Since short sellers sustain losses when share prices go up, they will start to cover their losses by buying back the shares they borrowed for more than their sale price. The combined purchases of both regular investors buying and short sellers covering can boost stock prices even higher, causing a snowball effect where additional short sellers cover.
While this process occurs organically in the markets, stockholders can conspire either individually or as a group to create a short squeeze. This process works in one of three ways. A stock promoter can buy a stock with a considerable short position and then spread misleading or illegitimate information to boost the price of a stock in a scheme known as a pump and dump, according to the SEC. Stockholders can also leak privileged information obtained from the company they invested in order to create a short squeeze. Thirdly, large investors can turn small profits by buying up thousands of shares of stock in a short time frame to create a sense of false demand, forcing short sellers to cover their losses.
The penalties for creating an illegal short squeeze vary depending upon the method the stockholders used. Under the Securities Exchange Act (SEA), inside traders will pay a penalty to the U.S. Treasury of up to three times the profit they received or loss they avoided by causing a short squeeze and may face criminal charges initiated by the U.S. Department of Justice. Stockholders who manipulate equities through trading activities or misleading information to create a short squeeze face fines of up to $5 million and a prison sentence of up to 20 years, per Section 32 of the SEA.
The SEC will not penalize stockholders who did not deliberately intend to profit from a short squeeze. Shareholders can profit off a short squeeze if they notice the situation developing organically, such as in the case of a company that reports better than expected earnings, but they cannot create the situation themselves. Under the SEA, manipulation of the stock market is illegal even if the manipulator did not profit from his actions.
- University of Cincinnati College of Law: Securities Exchange Act of 1934, Section 32 - Penalties
- University of Cincinnati College of Law: Securities Exchange Act of 1934, Section 21A -- Civil Penalties for Insider Trading
- University of Georgia, Terry College of Business; Liquidity and Asset Prices -- The Case of the Short Squeeze and the Returns to the Short Position; Paul J. Irvine and Kumar Vekataraman; August 2006
- U.S. Securities and Exchange Commission; Enforcement Tips and Complaints; April 2011
- U.S. Securities and Exchange Commission; Manipulation; March 2008
- Spencer Platt/Getty Images News/Getty Images