Definition of Short Squeeze
A short squeeze is a direct result of the lack of supply and demand in a security. The resulting affect of the squeeze is a sharp rally in the price of the security.
What Causes a Short Squeeze
Short squeezes can occur on any trading timeframe. However, the most powerful short squeezes occur after a security has been in an extended downtrend. As the security moves lower, traders use each dead cat bounce as an opportunity to add to their short positions. Over time, as the number of traders short continues to increase, there develops an imbalance of supply and demand. There comes a point where there is a lack of supply due to the constant selling. This leads to some initial buying and due to the large amount of shares outstanding that are short, it leads to short covering which generates the “squeeze”.
Profiting from a Short Squeeze
In order to profit from a squeeze, it requires a touch of luck and a lot of skill. Traders will check the days to cover on a stock (which is released by the Nasdaq bi-weekly) and assume that if the ratio of shares short is really high, then the stock is a good buy. This couldn’t be the furthest thing from the truth. The number of shares short is high for a reason; the stock is clearly underperforming the market. A better approach is to wait for a stock to approach a multi-year support level, or have a climatic volume event. This can generate the short-term buying power necessary to start a short squeeze in such a stock.
Short Squeeze Charting Example
The below chart example is from the stock Lehman Brothers from the spring of ’08. Notice how the stock had a sharp sell off down to 20, only to trigger a short squeeze that shot the stock back up to $50 in 2 trading sessions.