The resurgence of GameStop (NYSE: GME) has a lot of people asking how a short squeeze works. A short squeeze occurs when speculators that sold borrowed shares of a stock they did not own must buy shares of that stock later to close out their positions.

If too many short sellers buy the same stock at the same time, the price can take off. That’s what happened last month when GME soared from below $18 to above $64 in less than two weeks.

In that case, several individual investors acted in tandem to drive up GameStop’s share price quickly by buying the stock in unison. Short sellers had no choice but to also buy the stock to avoid taking a huge loss in their positions.

This isn’t the first time that GameStop has been the target of a short squeeze. Three years ago, I wrote about the initial (and very successful) effort to induce a short squeeze in the stock.

The market mayhem created by that event exposed every short seller’s vulnerability. A sudden and unexpected rise in a stock that they sold short can wipe out all their gains, and then some.

That’s why it is much harder now to induce a short squeeze. After the first GameStop debacle, all the major stock exchanges implemented new requirements designed to make it harder for a group of investors to ambush a stock like that.

Profit Instead of a Loss

There is nothing intrinsically illegal or unethical about a short squeeze. Sometimes, a stock with a lot of short interest suddenly goes up for a perfectly valid reason.

Case in point is athletic apparel retailer Foot Locker (NYSE: FL). Foot Locker has been on a downward trend for the past three years after losing its exclusive marketing agreement with Nike (NYSE: NKE).

That development was viewed on Wall Street as an existential threat to Foot Locker. So much so that short interest in Foot Locker was up to 16% at the start of this week.

Short interest above 10% is considered high and indicative of a potential bankruptcy. If the company goes bankrupt, then its stock becomes worthless. When that happens, short sellers can close out their positions at almost no cost.

Until last week Foot Locker’s short sellers were feeling pretty good about the odds of the company failing. But on May 30, Foot Locker released its fiscal 2024 Q1 results that refuted that notion.

During the quarter, Foot Locker booked a profit of 9 cents per share. That isn’t much, but it’s a profit instead of a loss. On a non-GAAP (generally accepted accounting principles) basis, that profit expanded to 22 cents per share.

The company also provided guidance for the remainder of this year that included an estimated profit of $1.50 – $1.70 per share. That doesn’t sound like a company that is headed for bankruptcy.

Squeeze Play

That day, Foot Locker’s share price rose from below $23 to above $29. It has since settled in around $27, about 30% above where it was trading two weeks prior.

Some of that gain is due to investors who now view Foot Locker as a deep value turnaround play. If the company’s estimate for earnings this year proves accurate, its current forward earnings multiple of 17 looks cheap compared to a multiple of 21 for the S&P 500 Index.

However, more of that initial gain (circled area in chart above) was probably due to short sellers closing out their positions. At this point, they have more downside risk than upside potential.

I am interested to see what the short interest is in Foot Locker a few weeks from now. My guess is it will fall below 10%, at which time the stock should no longer be vulnerable to a short squeeze.

That does not mean that Foot Locker’s problems are behind it. Even though it is profitable, its top line sales declined during the past year and are projected to be flat this year.

Even still, there does not appear to be much downside risk in Foot Locker given its improving operating metrics. But there are plenty of other companies that are struggling.

You don’t have to be a Wall Street pro to know who they are. You can see the short interest in any stock for free at shortsqueeze.com.

Somewhere in there is the next Foot Locker. If you time it right, you can make a lot of money by anticipating a short squeeze shortly before it happens.

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