Is a Short Squeeze Good or Bad?

 

 

 

Short squeezes can pose as either an opportuntity or as a threat for traders.

Is a short squeeze good or bad? It depends on what side of the trade you are on. If you are shorting a stock or buying puts on a stock, a short squeeze can lead to losses. On the other hand, if you are going long a stock or buying call options, a short squeeze may lead to profits.

The rest of this article will explain what a short squeeze is, how you can recognize one, and how you can avoid losses and even profit from them when they happen. So if you want a more detailed answer to determine is a short squeeze good or bad keep reading.

Shorting a stock

To understand what a short squeeze is, let’s begin with the concept of “shorting.” A stock trader “sells a stock short” or “shorts the stock” when he borrows shares and sells them into the market. Once he does this, he knows that he will need to buy the shares back at some point in the future to pay cover his short shares.

However, he expects that when he buys the shares back, they will be a lower price than when he sold them or he wouldn’t short the shares. 

Shorting shares is, in essence, a loan as seen in the images below.

shorting a stock
Image by Grochim

If the trader is correct that the share price will drop, he will be able to pocket the difference between the price he sold the stock at and the price it is when he buys it back and pays off his loan.

For example, let’s say that Joe borrows a share of company A and sells it for $100 at 1 p.m. By 2 p.m., the price of company A stock has fallen to $90. At this time, Joe buys the stock back and returns it to his broker. Joe made $100 when he sold the share, and he had to pay $90 to get it back. So his profit is $10.

This is a simplified example. In real life, Joe would have to pay a fee to borrow the stock, and he would have to pay a commission to his broker for executing the trade. These fees would eat into his profit.

In addition, he would probably want to short more than one share. But aside from these small details, this is how shorting a stock works.

Read our related post How to Use Options to Predict Stock Prices.

Short Squeeze

Now imagine that a company is in a lot of trouble. The news media just broke a story that the company’s executives were caught in an accounting scandal. Or a new product came out that has made the company’s product obsolete. Or some new shareholder information was just released that shows rapidly falling revenue.

Whatever the reason, expectations around this company’s future have suddenly turned very pessimistic.

Going short

In situations like these, it is very common for stock traders to go short in large numbers. All of the sudden, traders everywhere are borrowing this stock from their brokers and selling it short.

But there is one problem with this strategy: if nearly everyone is going short, they will all eventually have to buy the stock back. After all, these traders don’t actually own the stock they are selling.

Changes in information

Now let’s imagine that some good news comes out about the company. Maybe a new report is released that shows revenue is falling at a slightly slower rate than was anticipated. Or perhaps new evidence comes out that the executives might not be guilty of fraud.

Under normal circumstances, good news like this may only have a slight effect on a stock’s price. But when there are a lot of people shorting a stock, even the slightest of good news can cause a massive rally.

First, traders who stayed on the sidelines start to buy up the stock because it is perceived as a bargain.

Next, traders who are short are faced with mounting losses.

When shorts exit

To prevent themselves from suffering even greater losses, the traders who are short begin to buy up the stock and pay back their brokers. This buying causes the price to rise even further, which causes other traders who are still short to lose even more.

This cascading effect is what is called a “short squeeze.”

If you are a stock trader and are short, being in a short squeeze may be very uncomfortable. But if you are long, it may be a wonderful experience.

In the same way, if you are an options trader and are buying puts, a short squeeze is bad for you. But if you are an options trader and are buying calls, a short squeeze is usually good for you.

To sum up: you should try to avoid short squeezes if you are selling stocks short or buying puts. If you are going long stocks or buying calls, you should look for short squeezes as an opportunity.

How to Detect a Short Squeeze

Now that we’ve considered what a short squeeze is and when it is good or bad, let’s discuss how to detect when a short squeeze is coming.

Short interest as a percentage of float

The first sign that a short squeeze may be about to happen to a stock is that it has a high short interest as a percentage of float.

If you want to calculate this figure yourself, take the total number of shares available and subtract the number of shares that can’t be legally sold (such as those “vested” by company officers). This is the “public float;” the number of shares available to be publicly traded.

Then take the number of shares sold short and divide it by the public float. This is the short interest as a percentage of float.

short interest as a percentage of float

If you don’t want to do this math yourself, most brokers publish this information from within their trading interface.

As a rule of thumb, a stock with a short-interest as a percentage of float above 50% is considered high. The higher this figure is, the more likely a short squeeze will occur, assuming other factors are also in place.

Read our related post What Is Considered a High Short Interest Ratio?

Days to cover

days to cover
Image from NASDAQ.com

Another sign that a short squeeze may be about to occur is that the stock has a high days to cover. To know a stock’s days to cover, divide the number of shares sold short by the average daily volume. This tells you how many days it would take for all of the shorts to buy back the shares they have sold.

As a rule of thumb, a stock with a days to cover above 10 is considered high. In general, the higher this figure is, the more likely a short squeeze is to occur.

Rising trend

The third signal to look for when trying to detect a short squeeze is a rising trend. The price needs to have broken above a key line of resistance or be in an upward sloping channel.

If the price is stable or continuing to fall, a short squeeze may never occur, or it may occur too late for you to take advantage of it.

But if the price is steadily rising, the short squeeze may be imminent.

Spike in volume

During the beginning stages of a short squeeze, volume rises substantially. It may rise by as much as 200-400% as shorts scramble to cover their positions.

If the price merely rises without any increase in volume, however, this may be a false signal. But if you see a stock with high short interest, a rising price trend, and rapidly rising volume, this provides even more evidence that a short squeeze is starting to occur.

Good news

The final signal to look for is some kind of “good news,” something to get traders to be less pessimistic about the stock.

This may not even really mean “good news” in the usual sense. Maybe it just means news that is less bad than anticipated.

For example, for a company that has been running financial losses, “good news” may mean profits. But it could also mean losses that are smaller than expected in the latest quarterly report. (Read more in our post How to Play Earnings)

Either way, for a short squeeze to occur, investors need some kind of new data to make them more optimistic than they were before. So if you see a stock with a high short interest, rising price trend, spike in volume, and recent good news, this is strong evidence that you may be seeing a short squeeze.

How to Profit From a Short Squeeze

Suppose that you think you are witnessing a short squeeze. What can you do with this information to make successful trades?

One course of action is to buy the stock. This will allow you to sell it once the short-squeeze ends. However, this course of action is also very risky. If the short squeeze ends quickly and reverses, or if you are witnessing a false signal, you can lose a significant amount of the money you put into the stock. You can even possibly lose all of it – if the stock should drop to zero.

Another course of action is to buy a call option on the stock. If the price continues to rise, you can then use this option to purchase the stock at a lower price and then sell it at a higher price, or you can just sell the option to someone else at a higher price than you bought it at.

Buying an option instead of a stock limits your losses when compared to buying the stock outright.

If the price reverses, you can only lose whatever you paid for the option. However, this also prevents you from benefiting from the trade if the short-squeeze takes so long to play out that your option expires.

You also have the risk of the option price declining due to time value deteriating as explained more in our Options Education and How to Trade Options 101 posts.

Either way, these are the possible ways to profit from a short-squeeze.

When is a Short Squeeze Good or Bad?

To summarize, a short-squeeze is good for you if you are long a stock or own a call option on it.

A short-squeeze is bad for you if you are short a stock or own a put option on it.

To detect a short-squeeze in the making, look for high short-interest as a percentage of float, high days to cover, a rising price trend, spiking volume, and some kind of good news.

To make a trade based on a belief that there is a short squeeze happening, you could buy the stock or buy a call option on the stock.

Images:

“Short (finance)” by Grochim: https://en.wikipedia.org/wiki/Short_(finance)#/media/File:Short_(finance).png

“Dozen-days to cover” (screenshot from NASDAQ.com): https://www.nasdaq.com/investing/dozen/days-to-cover.aspx

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