59.3 F
New York
Sunday, June 4, 2023

Short Squeeze: What Is It & How to Spot It

Market News

Joshua Rodriguez
Joshua Rodriguezhttps://cnafinance.com
Hey, Im Joshua, the founder of CNA Finance. I enjoy following the trends in the market and finding the catalysts that are making the moves. If you want to get in contact with me, leave a comment below or email me at [email protected].

Short squeezes were made popular as meme stocks like AMC Entertainment Holdings (NYSE: AMC) and GameStop Corp. (NYSE: GME) made dramatic runs for the top in 2021. These are far from the first short squeezes in history and haven’t been the last either. 

Below, we’ll talk about what a short squeeze is, some of the biggest short squeezes that have taken place in history, and how to spot one of these events on the horizon. 

What Is a Short Squeeze?

A short squeeze is a market phenomenon that takes place when a heavily shorted stock moves up in value. Traders with short positions buy to cover, resulting in a tremendous run for the top. Here’s how it works:

  • The Short Sellers: Short sellers are traders who believe the stock is going to fall in value. To take advantage of this prediction, they borrow shares and sell them into the market immediately. When the stock falls, they repurchase the shares to return them, making the spread (difference between the selling price and buying price) as profit. 
  • The Stock: The target stock in a short squeeze is one that’s heavily shorted. That means more than 20% of the stock’s public float is sold short. 
  • The Big Move: The company announces positive news or traders believe the stock has reached the bottom, leading to an increase in value. Short sellers start to lose money as the stock goes up. 
  • The Short Seller Reaction: In an attempt to stop the bleeding, the short sellers purchases shares in the open market to close their positions. This leads to a high volume of buying – sending the stock screaming for the top. 

Short squeezes typically lead to gains of more than 20% but have been known to cause stocks to more than double.  

How Public Float Plays Into Short Squeezes

A stock’s public float is the number of shares that are in the hands of investors rather than officers, directors, and those with controlling interests. As mentioned above, stocks don’t have a heavy short interest until at least 20% of the public float is sold short. When good news happens, short sellers race to cover, causing a short squeeze. 

However, if you could find a stock that has a small public float and is primed for a short squeeze, you may be in for significant gains. 

That’s because the market is a system of supply and demand. As the law suggests, prices decline when supplies are higher than demand. On the other hand, when supplies are lower than demand, prices rise. Think of a stock’s public float as its supply count. 

During a short squeeze, demand for a stock climbs tremendously as short sellers race to cover their positions. If the target stock has a small float – less than 10 million shares available to the public – stringent supply could lead to the stock doubling in value or climbing even higher. 

Short Squeeze Examples

Two of the best-known examples of short squeezes are GameStop and AMC Entertainment. In early 2021, traders worked together in an attempt to push institutional short sellers out of multiple big names in the stock market. 

From January 8th, 2021 to January 29, 2021, GameStop shares climbed from under $5 per share to more than $81 per share. The movement was so dramatic that social media participants were creating memes about the event – leading to an entirely new category of stocks – meme stocks. 

AMC experienced a series of short squeezes from January 8th, 2021 to June 18, 2021. In that time period, the stock had climbed from $2.14 per share to a high of $59.26 per share. As mentioned above, these are some of the most popular examples of short squeezes, but they’re far from the only short squeezes in history. 

Short Squeezes Throughout History

  • Piggly Wiggly: One of the first big short squeezes in history happened in 1923, when traders started to short Piggly Wiggly. The company’s founder, Clearance Saunders, used his own money to purchase shares. He also worked with bankers to raise $10 million and purchase all but 1,128 shares of the company. The stock climbed by around 50%. Short sellers used the remaining public float to cover their positions and the NYSE permanently stopped all trading of the stock. 
  • Volkswagen: In October of 2008, Porsche announced that it owned a 74% stake in Volkswagen. At the time, short interest was relatively high on Volkswagen’s stock. On the day of the announcement, shares opened at €348 and closed at €517. The stock found its top at €999 per share the following day. 
  • Reliance Industries

Pros & Cons of Trading Short Squeezes

There are several pros and cons associated with trading short squeezes. Some of the most pressing are outlined below. 

Pros

The biggest pros associated with trading short squeezes include:

  • Massive Potential Earnings: Short squeezes are known for causing stocks to make a tremendous run for the top. All short squeezes result in short-term gains well over 10%, but many result in gains in the hundreds of percentage points – but keep in mind that these gains are typically short-lived. 
  • Excitement: Let’s face it. Most aspects of investing are relatively boring. However, when you see a stock flying like it’s got a pair of twin rocket boosters behind it, it’s a pretty exciting occurrence. So, trading short squeezes can be an exciting event. 
  • Easy to Spot: Finally, short squeezes are typically very easy to spot. Simply flind a few active stocks that are making tremendous runs, look for short interest, and strike on the stock that is indeed a short squeeze. 

Cons

Although there are plenty of reasons to start looking for short squeezes to trade, there are also some significant cons to consider before you start. Some of the most pressing include:

  • Impossible to Time: Short squeezes cause stocks to rise to ridiculous levels. However, it’s almost impossible to time when these stocks are likely to fall back down. As a result, many less-than-experienced investors take significant hits as the short squeeze ends. 
  • Risk: Because it’s impossible to time the reversal here, short squeezes are some of the riskiest events to trade. So, if you’re risk averse, this isn’t an option for you. 
  • Short-Lived: Short squeezes are typically a short-term event. So, you’re not going to make any serious long-term gains trading these events. In fact, if you jump in on a short squeeze and hold the stock for the long term, chances are you’ll lose and it will take a significant amount of time to recover. 

How to Spot a Short Squeeze

Spotting a short squeeze is relatively simple. Here’s how it’s done:

  1. Find Active Stocks: Use your favorite stock screener to find the most active stocks on the market. You can use Stock Twits or a number of other resources for this. While you look for stocks, specifically look for those that are experiencing more than 10% gains.  
  2. Look Into Short Interest: In order for a short squeeze to occur, there must be heavy short interest on the stock. So, look into short interest and ensure that it’s over 20%. If it is, there’s a good chance that the significant upward movement is likely the result of a short squeeze. 
  3. Trade the Squeeze: You’ve found a short squeeze. Now, it’s time to use your chart and the technical data within it to trade the squeeze. 

How to Predict a Short Squeeze

Predicting a short squeeze is slightly more difficult than finding one that’s already active, but it’s not impossible. Here are the steps:

  1. Find Heavily Shorted Stocks: Use a stock screener to find stocks with short interest that’s over 20%. After all, you need heavy short interest in order for a short squeeze to take place. 
  2. Look for Coming News: In most cases, a positive catalyst (positive news) starts the upward movement in short squeeze stocks. So, consider what news may be on the horizon. For example, did you find a biotechnology company with heavy short interest? Do they have a PDUFA date on the horizon?
  3. Assess the Possibilities: Now, it’s time to consider what the probability of positive news might be. For example, if the biotech company with the PDUFA date on the horizon recently had a meeting with the FDA that went well, there’s a highly likelihood their drug will be approved. That’s good news for a potential short squeeze. 
  4. Wait: Never start trading a short squeeze before it happens. Instead, wait to confirm your findings. Once the squeeze starts, you should have plenty of time to capitalize on the trade. 

Final Thoughts

Short squeezes are an interesting phenomenon in the stock market. Not only are they exciting to trade, they have the potential to yield significant returns. On the other hand, they typically come with high risk. So, only trade these events if you have a detailed understanding of technical analysis and how to trade fast-paced moves in the stock market. 

Article Resources

- Advertisement -
- Advertisement -

More From This Author