Short Squeeze Meaning
Short squeeze refers to the situation that arises when there is an unexpected increase in stock price, adversely impacting the short-sellers, who are then forced to buy the stocks at a higher price to cover their short position and results in a further increase in the stock price. Effectively, the short-sellers are squeezed out of their short positions, usually at a loss.
How to Identify?
Several technical indicators help in the identification of stocks that are ripe for a short squeeze. Some of the most common indicators have been discussed below:
- Short Interest: It indicates what percentage of the outstanding number of shares of a stock are owned by the short-sellers. If the value of short interest is significantly higher than the normal level, then there is the likelihood that a short squeeze is just around the corner.
- Days to Cover: This metric is calculated by dividing the total short-selling interest in a stock by its average daily trading volume. Theoretically, it indicates how long (in terms of a number of days) it will take for the short sellers to cover their position, assuming average trading volume. The higher the value of days to cover, the higher will be the probability of a short squeeze.
- Relative Strength Index (RSI): This metric indicates whether the market is in an overbought or oversold condition. If the RSI value is below 30, then it indicates that the market is oversold and undervalued, and hence there is a scope of a short squeeze.
Example of Short Squeeze
Let us take the example of the stock of company ABC Inc. Let us assume that a short seller has a short position on the company at $25 per share, while currently (31-Dec-2018) it is trading at $29 per share. However, owing to a sudden announcement on 07-Jan-2019 about a new product launch the price spiked to reach $35 per share by 25-Jan-2019 and the momentum seems unstoppable.
In such a scenario, the short seller is in deep trouble as he needs to cover his position and limit his losses. The short seller decides to purchase ABC Inc.’s shares immediately. Due to demand from various similar short sellers, the price of the stock goes further up, increasing the short seller’s loss. This is how the vicious cycle of short squeeze takes place, which is represented by the line portion of the line.
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Let us take the example of a real-life example of Volkswagen where the short squeeze resulted in a significant jump in stock price during October 2008. Apparently, the stock price shoots up from €210 per share to over €1,000 per share in just two days, making it the most valuable company in the world for a brief period of time.
The sudden change in investor sentiments happened due to Porsche’s announcement that it had expanded its voting shares in Volkswagen to 74%. The short sellers who expected the stock price to all were hammered and were forced to purchase the stock at €1,005 per share for short covering.
How to Trade Short Squeeze?
The first task is to ensure that the negative sentiment is overdone. The traders can use the technical indicators to establish that there is a large short interest in a particular stock. After that, they can:
- Buy the stock and sell when the short squeeze seems to be ending.
- Buy a call option on the stock and wait for the stock price to a certain high and then use it to book the profit. Otherwise, they can also sell the call option itself to another investor at a higher price and book the profit.
Although there are many instances where the stock prices moved up after they had a heavy short interest, there is no guarantee that it will always happen. There are instances where the stock price had actually fallen when they were heavily shorted. So, this risk is always there for investors who intend to profit from a short squeeze situation.
This has been a guide to What is Short Squeeze & its Meaning. Here we discuss how to trade it along with examples, identification and risks. You can learn more about from the following articles –