What is a Bear Squeeze?
A bear squeeze is a situation where sellers are forced to cover their positions as prices suddenly ratchet higher, adding to the burgeoning bullish momentum.
- A bear squeeze is a situation where sellers are forced to cover their positions as prices suddenly ratchet higher, adding to the burgeoning bullish momentum.
- A bear squeeze can be an intentional event precipitated by financial authorities, such as central banks, or it could be a byproduct of market psychology where market makers, taking advantage of waning selling pressure, intensify their buying efforts to push that security's price higher.
- Contrarian traders accumulate long positions in heavily shorted assets in the hopes that a bear squeeze might be in the offing.
Market Mentalities: Bulls Vs. Bears
Understanding a Bear Squeeze
A bear squeeze is a sudden change in market conditions that forces traders, attempting to profit from price declines, to buy back underlying assets at a higher price than they sold for when entering the trade.
A bear squeeze can be an intentional event precipitated by financial authorities, such as central banks, or it could be a byproduct of market psychology where market makers, taking advantage of waning selling pressure, intensify their buying efforts to push that security's price higher.
A bear squeeze engineered by a central bank is done with the intent of propping up the price of a currency in the foreign exchange market (FX). This is accomplished by buying large amounts of that currency, essentially reducing the available supply in the market, which results in that currency appreciating sharply and setting off a bear squeeze. While it is more common in the currency markets, a bear squeeze can happen in any market where the price of an asset is suddenly driven up. Sellers holding short positions in currencies, or other assets, must buy at the prevailing market price to cover their position, which, given the speed of the move, often results in significant losses.
Often a bear squeeze is associated with a short squeeze, a phrase that is more popular with the average investor. A short squeeze is a situation in which a heavily shorted security, such as a stock or commodity, moves sharply higher, forcing more short sellers to close out their short positions, which only serves to add to the upward pressure on that security's price. Market makers who can corner the market are likely to initiate a bear squeeze if they deem the circumstances to be ripe for such an event.
As the term implies, traders get squeezed out of their positions, usually at a loss. In the equity market, it is generally triggered by a positive development that suggests the stock may be turning around. Although the turnaround in the stock’s fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out, even if it means taking a substantial loss.
If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if a stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price goes even higher.
Profiting from a Bear Squeeze
Contrarians look for assets that have heavy short interest. Short interest is the number of shares that have been sold short but have not yet covered or closed out. Contrarians look for these assets specifically because of the chance of a short squeeze happening. These traders may accumulate long positions in the heavily shorted asset.
The risk-reward payoff for a heavily shorted asset trading in the low single digits is favorable for contrarians with long positions. Their risk is limited to the price paid for it, while the profit potential is unlimited. This risk is opposed to the risk-reward profile of the short seller, who bears theoretically unlimited losses if the stock spikes higher on a short squeeze.
As an example, consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials. There is considerable skepticism among investors about whether this drug candidate will work, and as a result, five million of Medico's 25 million outstanding shares have been shorted. Short interest on Medico is therefore 20%, and with average daily trading volume (ADTV) of one million shares, the short interest ratio (SIR) is five. This, essentially, means that it would take five days for short sellers to buy back all Medico shares that have been sold short.
Assume that because of the massive short interest, Medico had declined from $15 a few months ago to $5 shortly before the release of the clinical trial results. The announcement of the results indicate that Medico’s drug candidate works better than expected. Medico’s shares will gap up on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions, which leads to further buying and further appreciation of Medico's stock.