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I'm a novice to investing and I came across this Investopedia article which says:

However, short selling through ETFs is preferable to shorting individual stocks because of the lower risk of a short squeeze—a trading scenario in which a security or commodity that has been heavily shorted spikes higher

I don't understand why this is. If a couple of like-minded investors decide to short an ETF which is at the top of the sector it is tied to, there are plenty of opportunities for a short squeeze.

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    The one-word answer is "diversification". The same is true for older-style mutual funds.
    – keshlam
    Commented Nov 4, 2022 at 14:40

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"If a couple of like minded investors decide to short an etf" then share price is likely to drop. And it would take more than a couple of investors. But that's not a short squeeze.

For a short squeeze to occur, you need a stock with a high short open interest and then you need some event that triggers a large amount of buying (earnings beat, new product, merger talk, etc.).

The reason that this is unlikely with an ETF is that Authorized Participants will arbitrage the price difference between the component stocks and the ETF, driving price back into line.

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If someone does a short squeeze of a single company, then everyone who is short that company has a big problem. Someone who is short an ETF that includes that stock is going to also have a problem, but the problem will be attenuated by the fact that the stock is, for a well-diversified ETF, only a small part of the ETF. To get the full effect of a short squeeze, every stock in the ETF has to be squeezed.

To make Bob Baerker's answer a bit more explicit, part of the mechanism of an ETF is that there are entities called "Authorized Participants" that are allowed to create new units of the ETF by buying up the stocks that the ETF represents, and bundling them into the ETF. If there's a short squeeze on the ETF, that would raise the price of the ETF, and then the Authorized Participants would have an incentive to issue more units. If there is a short squeeze on one of those stocks, then the APs would have to pay a lot to buy that stock to make more units, so this can still be a problem, but as I said before, if the stock is only a small part of the ETF, then this increased price will only be a small increase, percentage wise, in the price of the ETF.

So shorting ETFs is more safe than shorting individual stocks, but one should still look at what's in the ETF to make sure there aren't underlying stocks that are vulnerable to short squeezes. And it's not just short squeezes that are an issue; when shorting in general, one should be careful about shorting things with high volatility, and ETFs generally have lower volatility than individual stocks, and so are safer to short.

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