When stock prices start to rise rapidly, short sellers want out. This is because an investor who shorts stocks only profits when the stock goes down. However, an investor's losses are a short squeezer's gains, because the short squeezer is able to predict the window of time in which a stock will be on the rise, buy into the stock and sell at its peak. Sound like an appealing technique? Let's take a look at how it works - and when it fails.

Understanding Short Squeezes
Before you can completely understand short squeezes, you have to understand how the shorts, which create opportunities for squeezes, work.

If a stock is overvalued, a short seller will borrow the stock through a margin account based on a hunch that the stock's price will go down. Then the short seller will sell the stock and hold onto the proceeds in the margin account as collateral. Eventually, the seller has to buy the stock again in what's called a buyback. If the stock's price has dropped, the short seller makes money because he or she can cash in on the difference between the price of the stock sold on margin and the reduced stock price paid later. However, if the price goes up, the buyback price could rise beyond the original sale price, and the short seller will have to sell it quickly to avoid higher losses.

Example - The Anatomy of a Short Sale
Suppose that Company C was borrowed on margin and that "Short Seller Bob" then sold 100 shares at $25. Several days later, Company C's stock price drops to $5 per share and Bob buys it back. In this case, Bob earns $2,000 [($25 x 100) - ($5 x 100)].
However, if the stock price increases, Bob is still liable for the price of the stock when he sells it. So, if Bob buys back the stock at $30 instead of $5 as in the example above, he loses $5 per share. That $5 times 100 equals $500 that Bob has to pay up.

But what if Bob isn't the only short seller who wants to buy back shares before they lose even more money as the stock rises? He'll have to wait his turn as he tries to sell, because others are also clamoring to get rid of their stock, and there's no limit to how high the stock could climb. Therefore, there's no limit to the price the short seller could pay to buy back the stock.

This is where the short squeezer comes in and buys the stock - while the panic-stricken short sellers are causing a further rise in price due to short-term demand. In this case, the savvy short squeezer who buys the stock while it's going up must still swoop in at the right time and sell it at its peak.

Predicting Short Squeezes
Predicting a short squeeze involves interpreting daily moving average charts and calculating the short interest percentage and the short interest ratio.

Short Interest Percentage
The first predictor to look at is the short interest percentage: the number of shorted shares (short interest) divided by the number of shares outstanding. For instance, if there are 20,000 shares of Company A sold by short sellers and 200,000 shares of stock outstanding, the short interest percentage is 10%. The higher this percentage is, the more short sellers there will be competing against each other to buy the stock back if its price starts to rise.

Short Interest Ratio
The short interest ratio is the short interest divided by average daily trading volume of the stock in question. For instance, if you take 200,000 shares of short stock and divide it by an average daily trading volume of 40,000 shares, it would take five days for the short sellers to buy back their shares.

The higher the ratio, the higher the likelihood short sellers will help drive the price up. A short interest ratio of five or better is a good indicator that short sellers might panic, and it's a good time to buy a short squeeze.

Daily Moving Average Charts
Daily moving average charts show where the stock has traded for a set time period. Looking at a 50-day (or longer) moving average chart will show whether there are peaks in a stock's price. To view moving average charts, check out one of the many charting software programs available. These will allow you to plot this on your chosen stock's chart.

News about industries that indicate trends are also good indicators of a potential short squeeze, so stay informed about what is happening in your stock's field.

Risks Involved
If the stock has peaked, it could fall. The success of your short squeeze will depend on your ability to sell a stock at its peak.

Employing a short squeeze strategy is not without risk, but the risk is reduced by careful study of short squeeze predictors including short interest, the short interest ratio, daily moving averages and industry trends.

Related Articles
  1. Active Trading Fundamentals

    Short Selling: Making The Ban

    Short selling has been around as long as the stock market, and it hasn't always been looked on favorably.
  2. Options & Futures

    Bear Put Spreads: A Roaring Alternative To Short Selling

    This strategy allows you to stop chasing losses when you're feeling bearish.
  3. Options & Futures

    Short Sell Your Home To Avoid Foreclosure

    Are you in danger of losing your home? Protect your credit score with a real estate short sale.
  4. Options & Futures

    The Truth About Naked Short Selling

    The media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.
  5. Active Trading Fundamentals

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  6. Professionals

    How to Create a Client Investment Policy Statement

    Investment policy statements are vital for financial advisors and their clients. Here are some tips for creating them.
  7. Stock Analysis

    Will WYNN Continue to Rally?

    Wynn Resorts has experienced a rally recently. Will it remain a good bet?
  8. Stock Analysis

    Will Twitter's Stock Find its Wings Soon?

    Twitter is an enigma to many investors, but its story is pretty straightforward.
  9. Retirement

    When Annuities Are the Wrong Investment

    Understand how annuities provide several unique benefits, but many drawbacks as well, and identify the situations where they are not the best investment.
  10. Investing

    Casella Waste Faces Activist Pressure

    Casella has a valuabe collection of assets that activist investor JCP Investment Management believes are mismanaged.
  1. How safe are variable annuities?

    Life insurance companies are facing a challenging environment. Those that sell variable annuities have been able to mitigate ... Read Full Answer >>
  2. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  3. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
  4. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  5. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  6. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!