Short Squeeze – What is it and How to Identify the Setup
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Short squeeze is a term that you might come across every now and then. It usually coincides with a stock that was posting a strong decline but suddenly bounces back.
Short squeeze is often associated with shorting stocks. It is a fundamental proposition that states that shorting stocks is risky. It usually brings about negative connotations. Still, there are many who make money by shorting stocks.
For example, Carson Block who earned a reputation of being a short seller in stocks. In a recent interview with CNBC he shares his view on short selling in this article.
Block is just one of the many traders out there who make a profit by simply going short on stocks. Working at Muddy Waters, Carson Block specializes in shorting stocks, not just on the American stocks but world-wide as well.
His research, from his website here gives numerous fundamental reasons for shorting a specific stock. There are many ways to trade the short squeeze. Most importantly, it takes a lot of market observation and a focus on the fundamentals to get it right.
Sometimes, there can be genuine reasons to short a stock.
And you might have observed by now that short selling is usually the playground of large hedge funds. This means that you need to have deep enough pockets to withstand the volatile. While retail traders also engage in short selling the lack of capital to fund the position can get in the way.
Still, short selling among the day trading community is quite common.
When talking about a short squeeze it is important to note that it does not mean that a stock is reversing. It could reverse, but there is no guarantee that a short squeeze will be followed by a reversal in the trend.
But, before we get into the details of identifying a short squeeze, we need to understand the psychology behind shorting stocks.
Why so much negativity when it comes to shorting stocks?
In order to understand this, we must first know how you can short stocks. Shorting or short selling is based on the investor or the day trader borrowing shares and selling them.
After shorting the stock, the short seller then closes the sell position and returns the stock back to the broker. There have been many studies and articles covering the risks of short selling. Some of the risks include margins.
One of the many examples that is often widely covered in the media are losses traders make when they are short. For example, Joe Campbell’s disastrous short position continues to remain as a top example.
Campbell had initiated a short position on KaloBios Pharmaceuticals. A small cap stock, Campbell was hoping to make a profit. However, overnight the stock rallied 800% while Campbell’s position was short.
The rally came on the news about Turing Pharmaceutical Company’s CEO Martin Shkreli taking a majority stake in KaloBios’ shares. You can read more about it here. Needless to say, the reversal put Campbell into a margin call and being heavily in debt with his broker.
Staying short can be risky!
But you might be wondering why short selling is considered bad. Well it is also risky!
This is because for the most part it takes a lot of research and fundamental backing to be short on a stock.
While a stock has the potential to make unlimited gains, on the flipside a stock could simply become worthless.
Secondly, shorting stocks take time to realize the profits. In other words, most of the times the company can just deny the rumors or allegations even if your conviction was right. This example about Valeant shows how the company kept denying rumors before eventually coming out in the open.
If you were short too early, it would have caused you some losses.
For an average retail investor, shorting stocks can be a risky gambit unless you have deep pockets with a portfolio that is diversified so it can absorb the losses.
There is no doubt that shorting a stock during a decline can produce tremendous results. However, the same cannot be said when a stock is rallying.
What is a short squeeze?
A short squeeze is defined a bounce or a jump in the stock’s price. The jump in the stock can happen due to numerous reasons.
What follows next is that the positions that are short tend to capitulate.
As short sellers feel the pain, they close their short positions (leading to a buy). This practice in itself becomes a self fulfilling prophecy and sends the price of the stock higher.
When large numbers of short sellers move in on a stock, that stock tends to move lower. But when the stock makes even a little move to the upside, the short sellers are required to satisfy the margin calls.
As the number of margin calls increase, short sellers tend to close their position by covering their shorts. This adds to the demand for the stock which evidently sends the stock price higher.
Let’s explain this with an example.
Tesla Inc (TSLA) is one of the most favorite go to stock for shorting and it makes for a great example.
For example, the chart below shows that between the periods of early March 2018 through early April, TSLA was massively shorted.
Price fell from the highs of $350 to a low of $250. However, notice how quickly the reversal took place. Short positions entered between $250 and $270 would have certainly felt the pain. Price posted a sharp reversal just above $250 to close above $280.
The reversal was met with the weak short positions covering their bets. This led to additional demand in the stock contributing to the bounce.
By now you must be wondering how you can use this information.
Why does a short squeeze occur?
Short sellers are usually dominated by short term to medium term sellers. These are not investors who are willing to and can ride out the short term declines in the stocks. As a result, the short sellers are very sensitive to price.
When selling short, traders have taken on a margin. This is risky in itself and when the short bets are wrong, short sellers need to put up more capital. The only other option is to liquidate their position, also known as covering the shorts.
Due to the price sensitivity, short sellers tend to close out their positions at the slightest hint of an upturn in the stock. Eventually, the short sellers are squeezed out leading to demand which in turn pushes the stock higher.
How to use the short squeeze to your advantage?
The first step is to figure out with the stock is in a rally or a decline. Once you identify the longer term trend, the next step is to look for the short position in the stock.
This is an important metric as it can tell you whether the short position is crowded. Usually, as the percentage of short float grows, you can anticipate a short squeeze. Of course, a lot of other parameters are required as well.
The short float ratio, as the name infers is a ratio that calculates the number of shares that are short compared to the total shares outstanding. For example, if a company has 10 million shares outstanding with the total number of short shares at 1 million, that is a one percent short float ratio.
In general terms, when the short float ratio is more than 40%, the market sentiment is bearish. This is because a large proportion of the shares are shorted. However, it is not uncommon to see the short float rate even higher at 50%.
The next illustration below shows how you can use this metric in your analysis. The below filter, from Finviz.com shows the mid-cap stocks traded on NASDAQ exchange. The short interest is set to higher than 30%.
Using the short interest filter, you can handpick stocks that are potential candidates for a decline. These stock picks will potentially show you the possibility of a short squeeze that can occur.
You can also pick stocks that have a smaller percentage of short interest if you want to short the stock. But this comes with a caveat. Just because a stock has a short interest it doesn’t mean that the stock will fall.
The short interest ratio can change from day to day.
Trading the short squeeze
There are many ways to trade the short squeeze. The most evident of all is to trade the squeeze itself. The catch however is in understanding when a short squeeze occurs. This can be difficult when you are trading real time.
As a day trader, one also needs to pay attention to the fundamentals which can potentially bring about a change in the direction of the price.
Trading the short squeeze ideally starts with picking stocks that are 30% or more on the short interest. This gives you some evidence of the bearish sentiment building. Due to the fact that there is no “perfect” short interest level, you will need to watch the stock closely.
Sometimes, a short squeeze can occur even in the midst of bad news. Therefore, at the risk of repetition, day traders must pay attention to the fundamentals.
You can start by looking at the short interest filter and also add some other technical indicators such as price trading below a 200-day moving average.
When you find a perfect combination of a fundamentally driven short squeeze alongside the technical indicators pointing to an oversold market and that is where money can be made.
Example of a short squeeze trade
Take the next example below for Shake Shack (SHK).
Around late December 2017, the stock was declining sharply. The short interest grew rapidly to 48%, according to this report from CNBC around the time.
If you look at the technical chart, as the short interest started to increase, price fell sharply. At the same time, the technical indicators were pointing to a bullish divergence. A bullish divergence is where the new low in price fails to form a new low on the oscillator.
We make use of the Stochastics oscillator in this example with the 200-day exponential moving average. As the price falls, around the quarterly earnings release, you see that the earnings per share was in line with estimates.
The short squeeze around the earnings release, along with the bullish divergence in the stock sent the price higher.
You can see that the first target comes in at the 200-day EMA, which marks a reversion to the mean.
There are three things to remember here:
- Increased short interest
- Short squeeze coincides with the fundamentals (earnings release)
- Bullish divergence from the technical indicators
When you have the combination of the above three, you can expect a ripe opportunity in the market to trade the short squeeze.
Due to the risks of short selling, it is a safer bet to trade the upside when a short squeeze occurs.
Besides the above strategy, you can also develop your own such as trading short when the short interest starts to build. However, due to the risks of short selling and the margin requirements trading the upside is always a better opportunity.