What is Short Squeeze?

There are numerous types of investors in the financial market. Some may be comfortable with doing intraday while others may be swing traders or short sellers and others may invest systematically and be called contrarian investors. However, one thing is certain in the financial market; every type of investor is affected by other investors with their investments. As the financial market is a place that creates a chain reaction of affecting factors, you must understand the terms that are common in affecting the financial market.

This blog will highlight one such term called the Short Squeeze and how it can allow you to make huge profits. The short squeeze is known for drastically increasing the price of a security, otherwise called a rally. If you can identify a short squeeze in the time, you can initiate a trade and profit hugely from the unprecedented increase in prices. However, to understand a short squeeze, it is vital to learn about short selling.

Short Selling

Short Selling means selling a stock that the seller does not own at the time of the trade. Short selling can be done by borrowing the stock through Clearing Corporation/Clearing House of a stock exchange which is registered as Approved Intermediaries (AIs). Under short selling, the short seller borrows the stocks from the other investors through the stockbrokers at the current price levels and sells them in the market right away, earning the selling amount.

After the short-sellers have sold the stocks, they wait for the price of the stock to fall. Then they buy the stocks again at a lower price from the market and give the stocks back to the stockbroker, who gives them back to the investors. The short sellers make profits from the difference in the initial selling amount and the lower purchase price. This is how short selling works and becomes the core of the short squeeze phenomenon.

What is Short Squeeze?

A short squeeze is one of the rarest stock market conditions that result in an unprecedented rally in the prices of a stock or any other tradable security. This happens when securities have an unusual number of short-sellers holding short positions and are waiting for the security price to go down. The short squeeze always begins when the price of the security rises unexpectedly. Such a condition, when added with a coincidence of numerous sellers selling their short positions to cut losses, constitutes a short squeeze and drives the security price to rally.

Understanding Short Squeeze: Why do Short Squeezes happen?

Suppose a stock has an unusual number of short-sellers. In that case, it means that if the price of the security rises by a significant margin, these short sellers may panic as they know they can incur losses if the price rise continues.

Now, imagine if you identify securities that have an unusual number of short-sellers holding the positions. It means that they have borrowed these stocks from someone else and are legally liable to pay them back even if they have to incur losses. However, as there are so many short-sellers, they all believe that the price will go down, resulting in profits.

In such a case, if any event or factor leads to the security rising in price, it creates a chain reaction leading to the short squeeze situation. Here, you must first understand that the price of a security rises further if the buying volume is higher than the selling volume.

Since the price of the security rises, the short-sellers panic and start to buy the shares they have already sold to cut their losses and give them back. With the security already having an unusual number of short-sellers, the heavy buying increases the buying volume, and the security price increases further. The higher the price goes, the more short-sellers buy the stocks to cut their losses, further increasing the security price.

This creates a chain reaction where the price increases right from the first short-sellers buying the stocks in panic and continues until the short-sellers stop buying the stocks. Short squeeze always happens because of panic buying by the short-sellers. Contrarian investors try to anticipate and identify a short squeeze and take positions in stocks that demonstrate a high number of short-selling positions.

Risk of Trading Short Squeeze

A short squeeze is a rare phenomenon, which also makes it risky. There have been numerous examples in the past that had demonstrated a rise in prices when they had an unusual number of short positions attached to them. However, there has been the same number of examples in which a short squeeze failed, even when there were unusually high attached short-selling positions. Hence, if you want to trade a short squeeze, you need to be highly cautious.

If a security has a heavy short interest, it does not mean that the price will necessarily rise. Here, you have to understand that short-sellers do extensive research before initiating a short trade. As the security has a heavy short interest, it means that the price is likely to fall. Hence, if you are looking to trade the short squeeze, you must have other indicating factors signaling that the security price will rise.

Things to consider while trading Short Squeeze

To ensure you are better positioned to mitigate the risk profile while trading short squeeze, the first thing to consider is the ‘short percentage of the float’. It is the percentage of the security available for trading being held as short positions.

Ideally, the ‘short percentage of the float’ should be at least above 10%. Only then the security can be termed as having a heavy short interest and a potential candidate for a short squeeze. A basic principle is that the higher the ‘short percentage of the float’, the higher the chances of it entering a short squeeze.

You should also consider that while trading short squeeze is the ‘short ratio’ or ‘days to cover.’ It is the total number of days taken to generate sufficient trading volume to buy all the short-sold securities back in the normal trading session. A ‘short ratio’ of a minimum of ten days is considered to be ideal as ten or more days can indicate that the security is getting crowded. Unless you want to get squeezed, you can avoid the trades after identifying the ‘short ratio’.

Final Word

A short squeeze is rare, but when it happens, it can allow you to make huge profits, given that you are not a short seller. Owning to situations like the short squeezes, short-selling is considered highly risky and can force you to incur huge losses. You must perform extensive research on a particular stock before you initiate a short trade. On the other hand, if you are a contrarian investor, you can utilize a potential short squeeze by identifying security that has a heavy short interest. However, it is always advised that you trade short squeeze only after analyzing the security based on other technical or fundamental factors.