Investors, beware: The short squeeze is back

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Wednesday was another good day in the stock market, with Nasdaq Composite (^IXIC 1.20%) Up more than 1% as of 1:30 pm ET. Market participants generally pointed to an inevitable recovery from a weak performance in 2022 and expressed confidence that the latest inflation numbers to be released by the Bureau of Labor Statistics on Thursday morning will continue to ease price pressures.

When you look at the day’s top performers, however, you’ll notice a number of well-known company names that have been in considerable financial trouble. This includes high quality stocks Bed Bath and Beyond (BBBY 47.83%) And caravan (CVNA 24.89%), which faced major headaches that posed an existential threat to their ongoing business. While shareholders of these companies are seeing surprising results on Wednesday, the gains are largely coming from a phenomenon that is completely short-term in nature and could reverse itself at any moment.

What is happening with these two stocks?

What Bed Bath & Beyond and Carvana have in common is that many investors have questioned whether they can stay in business. Bed Bath & Beyond announced yesterday that its revenue fell sharply in the holiday quarter, raising fresh concerns about its ability to stay afloat amid mounting pressure to return to growth. In fact, with less than a month to go before needing to make a large interest payment on a portion of its debt, many investors in the home goods retailer believe it can’t continue to operate without some form of protection. or relief from its creditors.

Carvana is also struggling with its debt, as rising interest rates drive up its financing costs even as used car prices pick up on its fundamentals. The car dealer still has a few years to refinance some of its long-term debt, but as economic conditions worsen, shareholders seem more skeptical than ever about Carvana’s future prospects.

Still, traders could not buy the stocks of the two companies in sufficient quantities on Wednesday. Shares of Bed Bath & Beyond jumped 44% by midday on Wall Street, while Carvana gained 23%.

Short squeeze value trap

The main problem with these stocks is that they have been hit hard over the past year and this has attracted considerable interest from short-selling investors. Yahoo! According to its figures, Bed Bath & Beyond sold 57% of its float and 32% of its outstanding shares as of mid-December. Financing. Carvana’s short interest was even more extreme, with 80% of its float and nearly half of its outstanding shares used for short selling.

When there is a lot of negativity about a stock, it becomes very attractive to those who want to bet against it. However, the short-sale approach leaves investors vulnerable to those who choose not to make their shares available for borrowing. Combine that with a limited number of shares outstanding in the first place, and short-sellers may have to pay much more to get back the shares they borrowed. This is known as a short squeeze.

The short squeeze could lead to huge profits that are far greater than what Carvana or Bed Bath & Beyond have seen so far. However, at some point, those holding for profits eventually begin to cash in on their positions, easing the pressure and ending the short squeeze. Often, this causes the stock to move lower and wipe out recent gains.

Don’t fall for FOMO with subpar stocks

There are plenty of stocks that have seen significant declines over the past year that are still there to do Has good fundamental business potential. In that case, bargaining can be a smart long-term strategy.

With many short squeeze stocks, however, bullish scenarios are simply not realistic. If you see a stock jump on a day like today for no apparent reason, ask yourself if there’s a short squeeze going on — and then remind yourself that you probably lost faith in that stock’s ability to reverse losses long ago.

Dan Caplinger has no positions in any of the stocks mentioned. Motley Fool has no position in any of the stocks mentioned. Motley Fool has a revealing policy.


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