How to Trade a Short Squeeze

When a stock's price starts to rise rapidly, short sellers want out, because they only profit when the stock goes down. They can face theoretically unlimited losses when shares rise. Their pain, however, can be a short squeezer's gain. 

Understanding Short Squeezes

Before you can understand short squeezes, you have to understand how short selling works.

If a short seller thinks a stock is overvalued and shares are likely to drop in price, they can borrow the stock through a margin account. The short seller will then sell the stock and hold onto the proceeds in the margin account as collateral. Eventually, the seller will have to buy back shares. If the stock's price has dropped, the short seller makes money due to 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 even greater losses.

Example of a Short Squeeze

Suppose that Company C was borrowed on margin by a trader who then sold 1short 00 shares at $25. Several days later, Company C's stock price plummets to $5 per share, prompting the trader to buy it back. In this case, they earn $2,000 [($25 x 100) - ($5 x 100)]. However, if the stock price increases, the short seller is still liable for the price of the stock when it is sold. So, if the trader buys back the stock at $30 instead of $5 (as in the example above), the loss is $5 per share, or $500.

But what if there are many short sellers who want to buy back shares before they lose even more money as the stock rises? In such a case, they have to compete with each other in a sense, because others are also clamoring to get rid of their stock—and there's no fundamental limit to how high the stock could climb as brokers initiate margin calls forcing shorts to buy to cover. 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. A short squeezer must not only learn to predict and identify short squeezes, but also pick the right time to sell the stock, which is at or near 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 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. (For more, see: What Short Interest Tells Us.)

Short interest ratio

The short interest ratio is the short interest divided by the average daily trading volume (ADTV) of the stock in question. For instance, if you take 200,000 shares of short stock and divide it by an ADTV 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 this may be a good time to try to trade a potential short squeeze.

Daily moving average charts

Daily moving average charts show where a 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 headlines can also trigger a short squeeze, so stay informed about what is happening in your stock's field.

The Bottom Line

Correctly timing a short squeeze can be a very lucrative strategy, but with this high reward potential comes high risk. Timing a peak is no easy feat. A trader looking to profit from a potential short squeeze should make a careful study of short squeeze predictors including short interest, the short interest ratio, daily moving averages, and industry trends.

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