Covering during a short squeeze

From Wikipedia

• Cornering the market consists of obtaining sufficient control of a particular stock, commodity, or other asset in an attempt to manipulate the market price. One definition of cornering a market is "having the greatest market share in a particular industry without having a monopoly"...

• Although there have been many attempts to corner markets by massive purchases in everything from tin to cattle, to date very few of these attempts have ever succeeded; instead, most of these attempted corners have tended to break themselves spontaneously.

From Investopedia

• In investing or trading, a corner is an act of one entity obtaining controlling interest of a business, stock, commodity or other security so that they may manipulate the price. Cornering may happen to a specific security or a market area if an individual or group of have established a significant degree of control. Another term for cornering is market manipulation. Unless you are a central bank, cornering and market manipulation are illegal.

The two most common cornering methods have colorful but fitting names.

• 1) The pump and dump those with an existing position attempt to boost the price of a stock through recommendations based on false, misleading or greatly exaggerated statements. This strategy frequently attempts to manipulate and artificially inflate a micro-cap stock. The culprits will then sell out leaving later followers to hold the bag.

• 2) Less frequent is the poop and scoop approach. Here a small group of informed people attempts to drive down a stock's price by spreading false information, rumors, and otherwise damaging information. If successful, the market price of the asset will fall as others sell. After the market selloff, they can then swoop in and purchase the stock at bargain prices, knowing the fundamentals of the business is sound.

In the U.S. the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulate and monitor activities involving securities and the commodities markets. Those entities are responsible for preventing, and in some cases prosecuting, attempts to corner the markets if the actions including any violations of applicable laws. SEC penalties can be both civil and administrative and may include disgorgement, sanctions, fines, and the loss of trading rights.

In addition to the stock market, at least in the US, there is another market in borrowing securities between brokers.

Brokers who have customers who are long (i.e. not short) the security (e.g. mutual funds) often have arrangements with the customers that they may lend out their securities to other customers or other brokers. As shares become more and more scarce to short, the borrowing cost for such shares increases. However eventually there may simply be none available.

This can happen quite frequently, such as when the company puts out a tender offer to buy back shares (people who want to submit their shares to the tender need them back first). Also, this happens when dividends are paid - the tax treatment of dividends versus "payments in lieu of dividend" can be slightly different (these are the payments made by the short seller to the owner of the stock when the dividend is paid).

The rule however is that before you can short the stock, you have to have a 'locate' - i.e. shares that you have located that you can sell short. As the availability of shares to locate dries up the borrowing costs increase.

Sometimes this is enough to make more people make shares available to sell (e.g. one could just buy the long stock and lend it out as a trading strategy).

However eventually a buy-in may occur, and you are notified that within a few days, you either have to close out your position or locate some other shares. If you don't, your broker will do that for you (and they're obviously not interested in you making a profit). As long as there is a price in the market, that is possible.

If the stock is not that liquid, then the broker will not make it available for shorting (this could happen while you have a short position).

Assuming that there was one group controlling most of the free trading shares, would it be possible for this controlling group to hold out and not sell any stock to drive prices higher, causing short sellers to NOT be able to cover?

The price would continue to increase until the exchange decided to halt trading (acting in this type of manner would be against various rules). If the exchange halted trading in a security then the short seller would not be able to cover.

How would a broker-dealer (on behalf of short sellers) close short positions if there are no willing sellers of the stock?

It wouldn't be able to. The price increasing is an incentive for holders of the stock to sell. I have not heard of situations where a stock is bid but no ask. The job of the market maker is to provide two sided quotes. If he cannot locate stock to sell, he would stop trading and trading and the stock would be suspended until the regulators identified the culprit.

In private companies this type of thing can happen, and illiquid companies too. This is why minimum criteria have to be met for a stock to be able to be sold short.

This happened in the not-distant past, with Volkswagen. Porsche owned almost 75% of the VW stock (counting call options they intended to exercise), and a German state government another 20%, leaving fewer shares outstanding than the number of shares shorted.