Strong rallies happen in all sorts of stocks for various reasons, such as a positive earnings release, a proposed buyout or a news announcement favorable to the company's future. A short-squeeze is another event that can drive the price of stock higher, and quickly. Profiting from a short-squeeze, or to avoid getting squeezed yourself, means understanding what short selling is, how it works, and ultimately being able to spot a potential short-squeeze.
What is short selling?
In the stock market most investors buy stocks, hoping to sell them at a later time at a higher price; they buy then sell. Short selling is the opposite. A trader sells first and then hopes to buy it back at a later time when the price is lower.
In order to short a stock it must be borrowed from someone who owns it. Brokers take care of this, so as long as a stock is shortable, then any trader with a margin account can short sell a stock.
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Say stock XYZA is trading at $100 and you believe it is overvalued. You can sell that stock, without owning it, simply by selling it in your trading account. If you sell 100 shares your account will be credited with $100 × 100 = $10,000 less commissions. Your account will also show a negative (-) 100 share position on that stock. At some point in the future you will need to get that share position back to zero, which is called “covering” your short position.
If the price goes up to $110 your account will show a loss of $1000 ($100 – $110 = -$10 × 100 = -$1000). If the price drops to $90, your account will show a gain of $1000 ($100 – $90 = $10 × 100 = $1000).
This is because if you buy back the 100 shares at $90, to cover your short position, it will cost you $90 × 100 = $9000. Initially you received $10,000, so by covering the short position you are left with $1000 in profit (less commissions).
You can cover a short at any time, for a loss or a profit. The higher the price goes the bigger your loss since the price can keep going up beyond where you sold it. The lower the price drops the bigger your profit; your maximum profit is the amount you initially received from the short-sale, but only if the stock goes to $0.
What's a Short Squeeze? How Does It Happen?
Short sellers are predominantly short to medium term traders, not investors who are willing to ride out multiple ups and downs in a stock. Therefore, short sellers are generally price sensitive. Short trades are taken on margin, and if the stock goes significantly higher against a trader’s short position, they may be required to put up more capital or be liquidated from the position.
Such pressure causes many traders to panic and buy to cover their position. This mass exodus of short positions causes a lot of buying, in addition to the buying that spooked the short positions in the first place.
Therefore, a short squeeze is when a high number of short positions in a stock are muscled by the buyers into covering their short positions for fear of big losses. This causes a sudden jump in the stock price.
A short squeeze can happen very quickly on small intraday moves—for example, if one trader has a large position and is forced out of it—but usually there is an “escalating” process. The price starts to rise causing some shorts to cover, which causes other shorts to cover, as well as bringing other short-term buyers who see what is happening.
There are always multiple factors affecting a stock, so it is not always perfectly clear whether a short squeeze caused a stock to suddenly rally (usually in the midst of a downtrend, which is why traders are shorting it) or it was something else. But a high short interest usually indicates some sort of squeeze went on if the stock pops very aggressively. ’Higher than average volume":http://traderhq.com/analyzing-trading-volume-ultimate-guide/ is also usually a tip off.
How to Trade and Profit from a Short Squeeze
Isolating what stocks could experience a short squeeze is the first step to learning to trade them.
There are number of criteria traders use to pick stocks that could experience a short squeeze. Two of the most popular ratios traders look at are:
- Short interest as a percentage of float. This is how many shares are short as a percentage of how many share are actually available for trade (not held by insiders). For instance, if a stock has a float of 10,000,000 shares a short interest of 5,000,000, the short interest is 50%. That is a high number and definitely noteworthy. A short interest above 20% is considered high.
- Days to cover is another ratio derived by taking the total short position (in shares) divided by daily average volume. If the short position is 5,000,000 shares and the stock only does 200,000 in daily average volume, it would take at least 25 days for the shorts to cover. The longer the days to cover the bigger the potential danger for the shorts. Their position is so big that it can’t be easily exited without jacking up the price and volume to get out.
The Wall Street Journal publishes a list of biggest short positions, ranked by Days to Cover and Shorts as a Percentage of Float, among other criteria.
Add the “Float Short” criteria to your screen on Finviz to see stocks with a high short interest.
Nasdaq shows current and historical short positions: http://www.nasdaq.com/symbol/bbry/short-interest.
Once a potential stock is found, there are two ways to trade it. Often the trend will be down, which is why so many traders are short and expecting it to go lower. When it looks like a short squeeze is occurring, take short-term long trades (buy) to take advantage of the potential spike in price. Often these spikes are short lived, as once a bunch of short position stop loss orders have been triggered (buy orders) the buying loses steam.
Figure 2 shows several potential short squeezes. We can assume they were short squeezes because of the strong volume, sharp price moves and the high short interest. Had the short interest not been so high in these stocks the moves higher would have likely been more muted.
These were short-term squeezes where the buying pressure was only sustained for a day or two. Figure 3 shows what the July 14 short squeeze looks like on an intraday chart.
A short squeeze needs a catalyst. For this trade it may have been the aggressive move above a short-term range. The strong volume indicates a lot of buy orders going through, potentially to cover shorts. The buying was sustained through nearly the whole day as shorts were forced to cover at any opportunity they could find. Buying continued into the close, which would have presented an opportunity to ext with a nice profit. Continuing to hold the long trade is possible, but these stocks can be quite volatile; the next day the stock sinks as the panic to cover is gone, and most of the traders who wanted out of their short position got out on the July 14.
The second way to trade a short squeeze is to only trade stocks that are in downtrends, and assume that the shorts have it right. Wait for the price to pop aggressively showing a potential short squeeze, and then as soon as the buying pressure ceases, enter a short position. This can be a short or medium term trade, since it is in alignment with the current trend.
Always keep in mind the high short interest if you are also short. If a large number of shorts get spooked it could result in a very sharp rally. Keep stop loss orders relatively tight to control risk.
The above charts show examples of short-term squeezes. But squeezes also occur over the long term. If there is a high short interest in a stock a trend reversal can act as a catalyst forcing many of those short positions to cover. Figure 5 shows as an example of this; as the trend reversed the number of short positions continually decreased until the uptrend ran out of steam (source: http://www.nasdaq.com/symbol/bbry/short-interest).
Risks and Rewards
Attempting to trade a short squeeze can be dangerous for multiple reasons. Mainly, there are always multiple factors affecting a stock, not just the number of short shares. A rally in a stock may just be a normal a rally, and not a short squeeze.
Typically a stock will be weak if there is a very high short interest. By attempting to buy and profit from the short squeeze you are potentially buying a weak stock. Instead of trying to take advantage of the pop higher in a down trend due to a potential short squeeze, wait for the price to pop and then begin to drop again, and hop on the short in the direction of the trend. Some shorts will have been forced out, but buyers may be temporarily exhausted and the downtrend may continue.
Buying a short squeeze can also be hard to time. The initial strong move often happens very quickly; traders need to have a list of stocks that are susceptible to short squeezes and be aware of catalysts (often a breakout of some sort) that could trigger a lot of buying a squeeze.
Since short squeezes can cause big moves in a small amount time, the reward is the profit potential. By shorting after a short squeeze the astute trader can a get a good price to participate in further downside if the downtrend continues.
The Bottom Line
Taking advantage of a short squeeze means short-term traders need to have a list of potential trade candidates, and be ready to pounce if enough buying commences to trigger a buying panic amongst the short sellers. Only act once price confirms your suspicions. If buying, strong buying should already be occurring. If looking to short after a short-term short squeeze, then wait for the buying to cease and selling to resume.
A high short interest doesn’t mean a stock will move higher, nor does it mean it will move lower. Ideally, you want to trade in the direction of the trend, and use short squeezes as a way to get into that trend, whether it is up or down.
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