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Short squeezes have captured the attention of many of the world’s best investors and traders, some of whom boast correct market forecasts, while others are humbled by the quick but destructive nature of short squeezes. This article will provide an overview of the basic concepts of a short squeeze while providing insight into how to manage and trade this controversial financial market phenomenon.
What is a short squeeze?
A short squeeze can be defined as the pressure that short sellers face to cover their respective positions (by buying to close them) due to a sharp rise in the price of a stock.
For example, Investor A borrows 10 shares of Company Z at $5 per share. A few days later, Company Z’s stock price surged to $10 per share, meaning Investor A is currently losing $50. The logic behind the short squeeze is that when short sellers (individuals who predict price declines) lose their negative positions as prices rise, the domino effect of those investors repurchasing shares to unwind their positions in order to avoid further losses multiplies. Shares rose.
A good example is the 2008 Volkswagen AG (VOW.DE) short squeeze, in which Porsche bought Volkswagen shares in bulk, roughly quadrupling the price and eventually attracting multibillion-dollar short sellers. The chart below shows the relative price increase between Volkswagen AG and the German DAX.
Volkswagen AG and the DAX Index:
There is no limit to how high the stock price can go when many short sellers try to buy back at the same time. This often leads to opportunistic investors looking to take advantage of the short squeeze by buying up.
What causes a short squeeze?
From the above explanation, we can summarize the events that lead to the bear squeeze scenario in the following list:
- Investors identify stocks they believe are overvalued and take a short position in that stock in anticipation of a decline, which can lead them to buy back the stock at a lower price (sell high and buy low).
- The stock price moved in the opposite direction of what investors expected, causing the price to rise rapidly.
- Short sellers then realize that the position is unprofitable and try to buy back the shares with minimal losses, causing the price to rise further.
Is a short squeeze illegal?
Short selling is illegal under SEC rules.
“Short selling and non-delivery of stocks at settlement with the aim of lowering the price of the security. Such manipulation typically violates various securities laws, including Exchange Act Rule 10b-5.”
How to trade a short squeeze
Trading around a short squeeze (often erroneously initiated by a large external third party) can be very dangerous and lead to significant financial losses. However, some traders use market movement warning signs to predict a potential bear squeeze. (i.e. GameStop saga, where traders are on different sides of the action.) This high-risk activity has the potential for high rewards in some cases. Some investors are trying to stem the impending short squeeze by monitoring several key indicators. First, the main metrics are:
market sentiment
Market sentiment shows the market’s inclination towards a particular financial instrument – in this case, stocks. Below are two possible ways to assess, time and interpret possible signs of an impending bear squeeze.
Short interest ratio:
Simply put, the ratio is a mathematical indicator that tells investors the average number of days it takes for short sellers to buy back borrowed shares. The ratio is calculated by dividing the total number of shares sold short by the average daily volume. For example, if you short 10,000 shares of Company A with an average daily volume of 1,000 shares, the short interest rate is 10. As a rule of thumb, a short interest rate ratio of 10 and above is considered high, and the more short positions that need to be covered, the greater the chance of a short squeeze.
Short Interest Percentage:
This percentage gives investors an up-to-date indication of how many short sellers are in a given stock. That is, if Company A has 10,000 short sellers with 1,000,000 shares outstanding, the short interest rate is 1%. The higher the number, the harder it is for short sellers to buy back shares when prices rise.
How to protect against a short squeeze?
As mentioned earlier, a short squeeze can lead to huge financial losses, but there are ways to mitigate excessive losses with two simple additions.
1. Stop Loss: Stop loss is the level at which the position is closed when the price reaches a certain level above. For example, if a stock is short at $10, a stop loss can be placed at $15, which means that if the stock reaches $15, a buy will occur and the position will be closed at a loss of $5.
2. Hedging: This may seem counterintuitive as it basically cancels out all profits, but buy orders can be placed at a certain level to limit losses to the desired amount. For example, an order to buy the above stock at $15 effectively acts as a stop loss.
Note: Traders should be aware of the risk of stop-loss orders. You are vulnerable to short-term price fluctuations that may activate the stop-loss price. All stop orders are executed, but there is no price guarantee. Also, when your level is hit, your stop loss order cannot be executed at a better price than your stop loss, only at the same or worse price, which may affect your initial risk/reward Rate.
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