Ever wonder what it looks like to see an actual short squeeze take place? Watch the price of this stock explode $2 per share in a matter of minutes.
Putting pressure on short sellers.
All stock investors feel pressure when they are investing. Most investors feel that pressure when stock prices are going down, but short sellers are a little different. Short sellers feel pressure when stock prices are going up.
How Do Short Sellers Get Squeezed?
Short sellers get squeezed when the price of the stock they have shorted begins to rise. This can happen because investors are feeling good about the stock and more and more are starting to add it to their portfolios, because some investors who sold the stock short are exiting their trades and covering their positions or a combination of both.
As the stock price rises, it either eats into a short seller’s profits or increases a short seller’s losses. Either way, the experience is unpleasant.
Plus, short sellers are usually in a leveraged position because they have borrowed the stock they have shorted from their broker. This means the pressure that comes from mounting losses is amplified.
What Happens When Short Sellers Get Squeezed?
When short sellers get squeezed, they try to minimize their losses by exiting their trades. To do so, short sellers have to go out into the market and buy back the shares of the stocks that they shorted. This added buying pressure continues to push the value of the stock higher, which leads to further pain for the remaining short sellers.
Soon enough, these short sellers begin to exit their trades by covering their short positions, and the cycle begins to feed on itself in a feedback loop that pushes the price of the stocks higher and higher.
Watching for Short Squeezes
If you want to find potential short-squeeze candidates, keep your eye on the short-interest levels of stocks that have been losing value. If the short-interest levels are high, watch for little turn arounds and signs of life. If the stock price begins to turn around, you may see a short squeeze in the making.
What is a ‘Short Squeeze’
A situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock. A short squeeze implies that short sellers are being squeezed out of their short positions, usually at a loss. A short squeeze is generally triggered by a positive development that suggests the stock may be embarking on a turnaround. Although the turnaround in the stock’s fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out even if it means taking a substantial loss.
BREAKING DOWN ‘Short Squeeze’
If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if a stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price is pushed even higher.
Two measures useful in identifying stocks at risk of a short squeeze are (a) short interest and (b) short-interest ratio. Short interest refers to the total number of shares sold short as a percentage of total shares outstanding, while short-interest ratio (SIR) is the total number of shares sold short divided by the stock’s average daily trading volume.
As an example, consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials as a treatment for skin cancer. There is considerable skepticism among investors about whether this drug candidate will actually work, and as a result, 5 million Medico shares have been sold short of its 25 million shares outstanding. Short interest on Medico is therefore 20%, and with daily trading volume averaging 1 million shares, the SIR is 5. The SIR means that it would take 5 days for short sellers to buy back all Medico shares that have been sold short.
Assume that because of the huge short interest, Medico had declined from $15 a few months ago to $5 shortly before release of the clinical trial results. When the results are announced, they indicate that Medico’s drug candidate works better than expected as a treatment for skin cancer. Medico’s shares will “gap up” on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions. A short squeeze in Medico is now on, and can drive it much higher due to massive buying pressure.
Contrarian investors look for stocks with heavy short interest specifically because of a short-squeeze risk. These investors may accumulate long positions in a heavily shorted stock if they believe its chances of success are significantly higher than believed by those who are bearish on it. The risk-reward payoff for a heavily shorted stock trading in the low single digits is quite favorable for contrarian investors with long positions. Their risk is limited to the price paid for it, while the profit potential is unlimited. This is diametrically opposite to the risk-reward profile of the short seller, who bears the risk of theoretically unlimited losses if the stock spikes higher on a short squeeze.