You might have heard how dangerous short squeezes can be. Actually, anytime you short sell a stock, you’re exposed to a potential short squeeze. What exactly is a short squeeze and how can you deal with it?
We’ll show you real-world examples, but first, we’ll provide a brief introduction to short positions is in order for a better understanding of how short squeezes can alter market dynamics. We will also see you can profit from estimating the timing of the event correctly.
Getting to Know Short Positions and The Short Squeeze
A short is completely opposite to the traditional market in that you do not buy low and then sell high. Instead, you sell high aiming to buy low later. What a trader does is that he simply sells his stock with the intention of covering it at a lower rate later or repurchasing it. This is how short positions work in essence.
The trader simply waits for the price to fall, as anticipated, so he could buy lower than he had sold and thus profit from the trade. However, things might not go as planned, especially if the trader finds himself facing a short squeeze.
A short squeeze is a situation in which a stock that is heavily shorted moves significantly higher and actually begins increasing in price and contrary to what was expected.
Thereafter, short sellers can’t take the loss and try to close out of their positions. If enough traders are in this position at once, you don’t want to get caught in the middle of a short squeeze because you could lose a lot more than you intended as traders all try to dispose of their positions quickly.
Moving Deeper Into A Short Squeeze
When you’re shorting stocks, you generally want to look at the number of “floating shares” and the “short interest”, or the percentage of floating shares that are short. A short squeeze is what the name implies; a stock runs up and squeezes shorts out of their positions.
When short sellers hit their pain threshold, they closeout, which adds to the buying pressure. Generally, stocks with a high short interest and a low float are prime for short squeezes. However, there needs to be some sort of catalyst for a short squeeze to occur.
When a stock has a high short interest, it could be primed for a short squeeze in the event of a positive catalyst. If there’s positive news surrounding a stock with a high short interest, there would be a ripple effect. Once there’s a positive catalyst, market participants enter the stock long, and drive the price higher.
This causes some shorts to close out their position, increasing the buying pressure. Thereafter, more shorts close out and add to the pressure. Therefore, when there is a high number of shares short, you might want to reconsider shorting the stock because it could be prime for a short squeeze. We’ve seen this happen with multiple stocks, ranging from Netflix Inc (NASDAQ: NFLX) to DryShips Inc (NASDAQ: DRYS). This situation is also applicable to penny stocks.
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How to deal with Short Squeezes and even make profits
I think it is really important to follow the news as it can easily catalyze short squeezes, along with following trends in the specific industry well.
While the short seller suffers from the troubles the short squeeze brings, the short squeezer makes the most of the situation to maximize his gains.
You see, during a short squeeze, the price movement is exactly opposite to what the short seller expects. This can result in unlimited losses, at least on a theoretical level. However, the key to making the most of a short squeeze is to be able to predict its timing to a reasonable degree of accuracy.
There is definitely a lot of risk in this endeavor. You will need to have skill with charts and technical analysis. The charts show the trading activity for a defined time period. Observe carefully for price spikes in a moving average chart spanning a period of 50 or more days.
Furthermore, you will also need to estimate the short interest ratio and the short interest percentage. The short interest percentage indicates the level of competition in the market. The short interest ratio is an indicator of the probability of the price going further up.
- Short interest percentage: The short interest percentage is obtained when you divide the number of shorted shares by the outstanding shares. The greater the short interest percentage, the greater will be the number of short sellers who would compete to purchase the stock in case the price increases.
- Short interest ratio: Simply divide the short interest by the average daily trading volume of the pertinent stock to get the short interest ratio. A higher probability of short sellers driving the price higher is indicated by a large short interest ratio.
What, in particular, is a good value that can help you get a clear vision? If the short interest ratio is 5, it could indicate that panic might soon arise between short sellers. What does that mean for you? It implies you could trade a short squeeze.
Trading short squeezes and profiting from them is not everyone’s ideal trade. This task requires a great deal of technical skill and experience and you will need to be able to predict the event with a great precision level. It is all about timing when it comes to short squeezes. Your best tools for this purpose will be the daily moving averages, the charts, your trading software, the short interest ratio, and the short interest itself.
Via Jason Bond;
“Blue Apron Holdings (APRN) was weak at one point and trapped a lot of shorts. The stock had a short interest of 30% and floating shares of just 61.59M. With positive news, this stock was prime for a short squeeze. KeyBanc Capital Markets analysts were bullish on APRN.
They noted, “Blue Apron’s business model is shifting with necessary urgency, and liquidity seems sufficient,” wrote the KeyBanc Capital Markets analyst team led by Edward Yruma. “Saturation, and some degree of fatigue, may make incremental advertising dollars less effective for the traditional meal kits. However, Apron’s move to offer on-demand meals (via Costco, other partners, and direct-to-consumer) should increase the addressable market.”
Based on this news and technical analysis, I ended up buying the stock for the potential short squeeze.
The stock popped around 10%, and I ended up taking profits. That’s pretty simple. Now, short squeezes could get crazier than this. You might see a stock pop over 30% due to a positive catalyst, coupled with a high short interest and a low float.”
The Bottom Line
You never want to get caught up in a short squeeze because it’s pretty difficult to get out of. Moreover, you might feel frustrated when something like this occurs. Generally, if you’re looking to short stocks, you would want to stay away from those with a high short interest and low float and you will also want to avoid news-sensitive stocks.
What if you wish to make profits from a potential short squeeze? First of all, you will need to hone your skills in technical analysis and understand the nuances of short interest and the short interest ratio in addition to the daily moving average chart.
It’s all about having the hindsight to be able to interpret what it is that lies hidden from plain view and to base your trading decisions on this. There are a lot of risks, without a doubt, but it is achievable if you know what you’re doing.
We highly recommend that you check out the Raging Bull page on technical analysis tools which will help you understand these techniques and use them in your trading. Making better trading decisions are often based on a thorough study of the charts and metrics.