What Is A Short Squeeze & How Does a Short Squeeze Work

2023-01-09 2023-01-09
Short Squeeze Explained

Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/

A short squeeze is always accompanied by a sharp rise in the share price, which is mistaken for a trend move. For sellers, this is a disaster since it occurs suddenly, and even the stop loss cannot help. Positions are closed with great slippages.

This overview will explain what a short squeeze is and how it works. Read on, and you will learn how to recognize a short squeeze, what risks it carries for buyers and sellers, and how to profit from it. 

What is a short squeeze?

What is a short squeeze? This is an unusual condition that triggers rapidly rising stock prices in a stock or other tradable security. It occurs due to a lack of supply of a particular security due to a large number of short positions previously opened.

Features of a short squeeze:

• The initial sharp rise in price has no apparent fundamental reasons. Positive financial results can only be a trigger.

• A short-term high is followed by a sharp decline in prices by 50%-70%, indicating massive buyers’ sales after closing most of the short positions. 

Stocks with relatively high liquidity that are most often shorted by traders become the target for a short squeeze. It doesn’t have to be a valuable company; there are examples of second and third tier non-blue chip stocks short squeezes.

A short squeeze has two targets:

• Buyers make profits at a price high as short sellers have to make purchases because of a stop loss or a stop out.

• Short sellers are squeezed from the market. The goal may be to deliberately inflict losses on specific large investors holding short positions. 

The short squeeze has a lot in common with the pump and dump strategy. In both cases, there is a sharp, unexpected price rise. In the case of a short squeeze, the price goes up due to the forced closing of short positions, while in the case of a pump, the price, on the contrary, grows due to an abnormally large number of buy orders, which appear most often by prior agreement.

How a short squeeze happens

The idea of a short squeeze is to use traders’ short positions against themselves. If the stock’s price goes up, short sellers will be forced to close positions manually, by stop loss, or by stopping out. Each close of a sell position is an additional purchase that increases demand and further pushes the price higher. A higher price means an increase in sellers’ losses. The flight of short sellers and their impact on a stock’s price are known as a short squeeze. Short sellers are being squeezed out of their positions, usually at a loss.

When opening short positions, a brokerage loan is used, which is called margin trading, and the short positions themselves are called short selling.

Margin trading works like this: 

• A seller, after analyzing the company’s past performance, believes that its stocks will become cheaper. For example, with the current price of a share of 100 USD, the security can fall in price to 80 USD.

• A trader asks a broker to provide him with shares on credit, which the trader will sell now for 100 USD, then buy for 80 USD and return the loan to the broker.

• The broker is ready to provide a loan secured by the remaining own funds of the trader. Suppose the stock’s price goes up instead of falling at some point. In that case, the broker will automatically close the trader’s short position (stop out), buying the shares necessary to repay the loan using the trader’s deposit.

A trader can protect a position and limit the potential loss with a stop-loss order. Stop loss, in this case, is an order to buy shares at a price, for example, 110 USD. That is, at a price, above which the trader is not ready to hold a position and suffer a loss.

How does a short squeeze work?

• A short squeeze is the desire of buyers to make money on those who opened short positions. Buyers are looking for a company that has a large number of shares sold short listed. That is, many investors took advantage of a brokerage loan.

• The purchasing phase begins. The reason for buying can be the creation of artificial demand or unexpected positive news, any trigger that will lead to the price rise and its exit from the usual trading zone.

• Due to the growing demand, the stock’s price goes up. Some of the short sellers see that their bets haven’t worked and close short positions ahead of schedule with a small loss. Closing short positions means buying shares and repaying the loan. More purchases increase the demand, and the price growth accelerates.

• The stock’s price continues to rise and reaches the levels at which stop-losses are set for those who still hoped the trend would turn down. Automatic closing of short positions again increases the volume of purchases.

• The remaining short positions are stopped out.

• At some point, most short trades are exited. The security is again sold short, and the price drops sharply.  

In the chart, a short squeeze looks like an unexpected sharp price rise, followed by a 50%-70% drawdown.

In theory, a short seller can live through the short squeeze, realizing that upon reaching the high, the price will drop by at least 50%. But this is only possible if such traders have enough margin to avoid a stop-out. Also important is the margin interest rate – the interest rate for borrowed stocks. In this case, it is better to close positions ahead of schedule at a loss than to wait for the price high (stocks can soar by 500% – 1000% or more) and wait several months for the next drawdown, paying the interest rate.

The situation with a short squeeze is exacerbated when the number of heavily shorted stocks exceeds the stock’s total number. This is possible when brokers, through investment banks, lend shares to clients that do not legally belong to them. When a mass buying of shares begins on a general panic, and it turns out that there is nowhere to buy them, the price of securities goes up even faster due to the domino effect.

An important note. Investment funds and exchanges are unwilling to disclose data on volumes and price levels of opened positions. There is an opinion that this information can be obtained from the exchange data Level 3 Market Data, but access to them is limited. There are also analytical resources, such as marketWatch.com, shortsqueeze.com, marketbeat.com, and so on. On their pages, you can find, for example, the Short Interest Ratio indicator. It is also said that the hedge funds themselves manage these resources, and how much you can trust their data is a question.

The key components of a short squeeze that should precede it are discussed in the following sections.

Borrowing on margin

A short squeeze is preceded by a large number of short trades entered for the stock. Investors are so confident that the company’s financial condition will worsen in the future that they open sell positions using leverage. Increasing the position volume increases the pip value. And if the price goes up, leveraged trades will be stopped out almost in the first place.

High short interest

A short interest ratio is the ratio of short trades in relation to the total number of transactions. It is not only about the number of positions but also about volumes. It will be difficult for a large trader with one big short trade to find all the volume at one price. If the stock price goes up, the short seller will be forced to close the position in parts at the rising price. An increase in the volumes of short trades relative to the total number of opened positions indicates a possible increase in volatility.

High “days to cover”

Days to cover indicate how fast short trades could be closed given a stock’s daily volatility. If shorts have 10 times their daily short volumes, they will need 10 days to close those trades. The higher this ratio, the more likely the stock will feature a short squeeze.

A “trigger” event

When the previous conditions are met (large volumes of short positions cannot be closed at once), a key reason is needed that knocks the price up beyond the usual price corridor. Most often, this is unexpectedly good financial statements or the purchase of large volumes of stocks by a large investor. The second option is often used by market makers on M5-M15 timeframes.

A self-perpetuating cycle

A short squeeze is based on the cyclicity of actions. It is preceded by stops set at different price levels for high-volume short trades. When the price reaches the nearest level on the rise, there is a search for the buyers’ volumes corresponding to the short position. And if there are no orders of sufficient volume, the stock price rises to the next level, where there is volume available for the purchase of outstanding stock. Matching the buy orders pushes the price further. This is the cycle that will end when the volumes of supply and demand are at the same price level.

Risks of trading in a short squeeze

A short squeeze carries no risks for long-term investors who bet on long positions. For them, this is even an opportunity to earn extra money on swing trading, as one can sell at the high of the short squeeze and buy after the price rolls back.

Risks for short-term traders:

• Buyer risk. Late entry risk and missed exit risk. At the initial stage of a short squeeze in the accumulation zone, the price rises slowly. Then comes a sharp upsurge. You need to open a long when the price is in the accumulation zone. After the end of the short squeeze, buyers begin to sell off shares, which creates a gap. If the buyer opened a long position too late and did not close it on time, there is a risk of losing money.

• Seller risk. The main mistake of the short sellers is the belief that buyers will not have enough volumes to break through the critical level, and the growth is a temporary correction to the overall downtrend. When the active phase of the short squeeze begins, every hour incurs big losses for sellers; the price rises so fast that the stops are triggered with slippage.

The rise in price during a short squeeze lasts from several hours to several days. The drawdown can happen just as instantly or stretch over several months.

Investment advice: Whether you are buying or short selling a stock, use a trailing stop instead of a usual stop loss. Thus, you avoid the need to constantly move stop-loss orders manually.

Examples of short squeezes

Below, I will explain several examples of short squeezes in the stock market. The reasons for the sharp price surge are different, but the result is the same, traders who bet on a price drop face a loss.

GameStop

It is probably the most famous example of a short squeeze in recent years. It showed that even retail investors could outplay large investment funds. And the big short can result in losses for the short traders themselves.

Until 2021, GameStop was an almost unknown retail chain selling computer games, consoles, and game accessories. Weak reporting, point-of-sale shut-downs, and declining earnings were the reasons why the company’s shares fell for six years in a row. Therefore, large investment funds have bet on short positions.

A large number of shares short positions attracted the attention of Reddit users. The topic of GameStop shares had been buzzing on the forums throughout 2020, with calls for buying out the shares starting to surface around December. In addition to the main goal of making money on a short squeeze, there was a message to “teach a lesson” to large hedge funds, which deliberately “drowned” the company with a large volume of short positions. And what seemed like a joke began to work.

A massive buyout of stocks in January 2021 pushed the price up, first to 20 USD and then to 40 USD. Andrew Left, the head of Citron Research, the major holder of GameStop short positions, has publicly ridiculed Reddit users’ attempts. But investment funds began to gradually buy back stocks to close short positions. Thus, on January 26, the GameStop stock price exceeded 120 USD. The funds lost about $6 billion, and some of them were forced to close.

Volkswagen

This example of a short squeeze is interesting because, amid the fall of all financial markets in the 2008 crisis, the German automobile manufacturer Volkswagen AG, for a short time, became the most valuable company in the world.

Short sellers hardly expected someone to be interested in large purchases of Volkswagen stock amid the crisis. So, the news about the stock buyout by Porshe took them by surprise. Quick attempts to cover short positions pushed the price even higher. A pullback followed, and traders returned to normal trading.

How to find the next short squeeze

Short squeezes are sudden phenomena, and it is almost impossible to predict them in advance. Most often, they are identified at an early stage, when the short squeeze has already begun. There are three main identification methods:

1. Monitor trader communities

GameStop and AMC sticks had no fundamental reasons to appreciate in 2021. But those who followed Reddit could see a potential pump of a heavily shorted stock from users. Although the start of the short squeeze was not known, it could be tracked in the early days.

2. Technical analysis

Here are several signs:

• After a downtrend, the price breaks up a sideways trend or a key resistance level.

• There is an active buying of large volumes in the Depth of Market. The price movement is much greater than the trend move in previous days.

• The trading volume is the highest at the price high. The slowdown in the price movement suggests an upcoming reversal.

Any formal reason is needed to start a short squeeze—collusion, news, good financial statements, anything that will trigger purchases.

3. Fundamental analysis

Statistics and different coefficients help identify potential targets for short squeezes. Examples of some coefficients:

Short Interest Percentage = Number of stocks sold short/Total number of shares outstanding. 

Short selling is short positions, the sale of stocks that the trader does not actually own. For example, if there are 1,000 shares in circulation and 100 stocks are sold short, the ratio is 10%. The higher it is, the more traders will be willing to purchase stock if the price goes up. A value of 20% is considered critical.

Short Interest Ratio = Volume of short positions/Average Daily Trading Volume. 

The Short Interest Ratio shows how many days short sellers need to close all short positions with purchases. For example, there are open short positions for 100 stocks, and the average daily trading volume is 20 stocks per day. This means that it takes five days to close all short positions. The higher this indicator, the greater will be the losses of those who short selling and do not have time to find stocks in time to buy in the right amount. You can read more about this ratio and the Days to cover indicator in the article Days to Cover: What Does Short Interest Ratio Mean?

The high Short Interest Ratio and the high Short Interest Percentage only indirectly suggest the likelihood of a short squeeze. The key point is the panicked short sellers. It is enough for at least some of them to begin to close short positions ahead of schedule in a panic, and the price will start rising, encouraging other traders to buy.

Who Loses and Who Benefits From a Short Squeeze?

Those, who opened short positions and did not manage to close them in time, lose. Those who set stops and managed to exit trades at the very beginning of the short squeeze have the smallest losses. The longer the short sellers look for resources to close short positions, the greater their losses. Those traders win, who opened long positions and sold short stocks on time at the price high.

Short Squeeze: Summary

• What is a short squeeze? This is a price increase that forces sellers to exit shorts at a loss, thereby pushing the price up even more and faster. The reason for a short squeeze may be the conspiracy of buyers to start simultaneous purchases or news that turned out to be positive despite most negative forecasts.

• Short squeeze risks for seller and buyer. The seller runs the risk of not finding the required volume for the complete closing of transactions and closing positions on a stop-out (the worst possible price). The risk for the buyer is to miss the moment of closing a long position.

• How to predict a short squeeze in advance. Follow discussions on trader forums, analyze statistics for short positions on analytical resources, and track unexpected price spikes. Always use stop-loss orders.

• How to make money on a short squeeze. Track the price trend. When a sideways trend or a strong resistance level is broken out upside, find the reasons for the breakout. Evaluate fundamental factors, and pay attention to the volume of orders in the Depth of Market. The matter is to enter a purchase at the beginning of a short squeeze and exit it at the price high. The earlier a long position is opened, the higher the earnings.

• What should a seller do with a short squeeze? Make sure that the price is really rising due to the short squeeze, and try to close short positions as quickly as possible. Do not go too far with using the leverage.

Early recognition of a short squeeze allows you to minimize the risks by exiting the market as soon as possible. Besides, you can make profits from a short squeeze using scalping strategies.