What is a short squeeze and how to trade it

The term short squeeze is one you may have occasionally come across but not been quite sure exactly what it meant. It typically occurs around a stock was showing a large decline, but then all of a sudden bounced right back. 

It is something that is quite often associated with stock shorting. It is a principal proposition, which declares that stock shorting is high risk. Even so, there are many investors out there that make big money from it. 

Legendary investor, Carson Block, made his name by short selling stocks. It was not just on American stocks where he earned big money, but also on stocks from across the globe. He is one of lots more who have made large profits from basically going short on stocks.

He has stated numerous times that there are many fundamental reasons as to why investors should short a certain stock. There are many different ways they can trade the short squeeze. What he said was most important was making sound observations of the market and getting the basics right.

There are often genuinely very good reasons why an investor should short a stock. This is why selling short is what large hedge funds predominantly focus on. However, it does mean that you need to have lots of funds available in order to withstand the highly volatile market. This is the reason why few retail traders sell short.

Nonetheless, within the daily trading community, selling short is reasonably common. When discussing the short squeeze it is important to remember that it does not, in anyway, meaning that the stock is reversing. It may reverse, but it is not guaranteed that it will be followed by a change in the trend.

However, before looking into that, we must first understand what the psychology is behind the shorting of stocks.

 

The negativity around short selling stocks

To understand this fully, it is helpful to know how stocks can be short sold. Short selling / shorting sees a trader lending shares and then selling them. Once the stock has been short sold, the investor closes the position and returns the stock to the broker. However, there are some risks associated with this, with them including margins. 

Another risk, which is widely portrayed, is the losses that can be made when an investor is short. One famous example is the short position that Joe Campbell held. He was responsible for having a short position on a pharmaceuticals company. In the hope of making a profit, Campbell actually ended up making large losses after the stock rallied overnight by 800% whilst his position was short. This came about as a result of a CEO of another pharmaceutical company taking a major stake in the one Campbell was shorting on. This put him into a margin call and he became heavily indebted to his broker.

 

A short squeeze – what is it?

It is defined as a jump up in the price of a stock and can happen for a variety of different reasons. When short sellers begin to feel the pinch their short positions are close, which leads to a buy. This, therefore, becomes a self fulfilling prophecy, which sends the stock price up.

When lots of short sellers make a move on a stock, the price of the stock tends to go lower. However, when it makes the smallest of moves upwards, those selling short must satisfy their margin calls. With the amount of margin calls going up, those investors selling short cover their shorts by closing their positions. This, therefore, adds to the stock’s demand and so sends the price of the stock up.

One real life example saw a stock value fall from highs of $350 to as little as $250. However, as a result of what was previously explained, a reversal took place. Short positions came in at somewhere between $250 and $270 but after the reversal closed at slightly over $280. This was due to short positions working to cover their bets. This resulted in extra demand for the stock, which then led it to jump up.

 

Why do short squeezes happen?

Short sells are generally dominated by medium and short term investors. These kinds of individuals are not wanting to or are not willing to hold onto the stock during any short term declines in its value. Because of this, those investors are highly sensitive to price fluctuations.

When investors short sell they have taken a margin. This is a risky thing and if they go wrong, the investor has to put in more funds. They other option they have is to make their position liquid. This is referred to as covering the shorts. As a result of their sensitivity to price, investors selling short tend to close the position at the smallest hint of an upward movement in the stock. Over time short sellers become squeezed out, which leads to the demand increasing, thus pushing the value of the stock up.

 

Making the short squeeze work for you

The first step here is to work out where the stock you are interested in purchasing is in a decline or a rally. Once identified you can then look for a short position on it. This will let you know if the position is crowded or not. As the number grows of short floats you are able to anticipate the occurrence of a short squeeze. However, lots of other things are also required to take place for this to happen.

The ratio of short floats works out the amount of shares, which are short compared with the total number of shares that are outstanding, e.g. a company which has 100 million shares that are outstanding and a total amount of short shares of 10 million, has a short float ratio of one percent.

Whenever the ratio of short floats is greater than 40 percent, the market is acting bearish. However, it is not uncommon to see the ratio above 50 percent.

 

What to take away

With all this information you should now have a better understanding of what a short squeeze is and how to spot the signs of one so that you can use it to your advantage in order to make some good profits.