Most traders have heard of the term Short Squeeze, even if they do not follow finance or the stock market that deeply.
However, many traders still do not understand exactly what a short squeeze is or how it works.
Fortunately, the workings of a short squeeze are not complicated, we just need to understand how shorting stocks work.
Once we understand the mechanics of stock shorting, understanding the short squeeze naturally flows from that.
Understanding how short squeezes work and being able to identify when they are likely to happen opens up a whole new range of profitable trades.
Short squeezes can result in sharp upward price trends that produce substantial profits for those prepared for the trading action.
Breaking Down the Short Squeeze
There are a few simple concepts that we need to understand before we can learn about the short squeeze.
Once these simple concepts are put together, it is easy to learn how a short squeeze works.
Short Selling
Before we can understand how a short squeeze works, we first need to understand how short selling a stock works.
In the financial world, short is a general term that means to wager that a stock will go down in price.
There are numerous methods to bet that a stock will go down in price.
However, in this particular case, we are referring to the act of short selling.
Short selling works by borrowing shares to sell now and then buying them back later (hopefully at a lower price) to return them to the lender.
If the borrowed shares are sold at $200 each, for example, and then bought back later at $100 each and returned, then the short seller makes a profit of $100 for each share.
Borrowing Shares and Margin Cost
So far short selling sounds pretty simple.
The difficult part is that the person who lends the shares to be sold needs to be paid for their time and the risk involved.
The short seller borrows the shares to be sold from the lender on margin.
Margin trading means that the short seller needs to deposit some fraction of the value of the borrowed shares with the lender as security.
Many jurisdictions require a 150% margin deposit for borrowed shares.
From our previous example, that would mean the short seller would need to deposit $300 for each borrowed share.
Margin Cost and Increasing Share Price
Now that we understand the margin deposit, we can see how the short squeeze works.
A short squeeze can happen when the price of the borrowed shares goes up.
Instead of the stock price going down so the short seller can buy the shares back at a profit, the stock price goes up.
Now the value of the margin also increases because the cost to buy the shares back has gone up.
If the price of the shares in our example increased from $200 to $400, then the new margin deposit, at 150%, would be $600.
This means that the short seller now needs to deposit an additional $300 to the lender to cover the difference in margin costs caused by the increasing price.
Increasing Share Price and the Short Squeeze
If the short seller has the funds to deposit and believes the share price will go back down, they can simply deposit the additional margin and wait.
However, if the short seller cannot afford the margin or if they want to close the position at a loss before it gets worse, then they need to start buying shares back from the market at the increased price to return them to the lender.
This is where the short squeeze comes in.
Every short seller who needs to buy shares from the market to close their position adds to the buying pressure for the stock.
The bigger the resulting cascade of stock purchases, the higher the price of the stock goes.
The more frantic buying there is of the stock, the more short sellers there are who want to close their position, which leads to an even bigger buying frenzy.
This creates a vicious cycle of increasing share prices forcing short sellers to close their positions, which only adds to even more increases in the share price.
The market will squeeze a stock by forcing short sellers facing unlimited losses to close their positions, thereby contributing to further rapid increases in price.
Trading a Short Squeeze
It can be very profitable for a trader to be able to identify a short squeeze in action before it happens.
Seeing a short squeeze before it happens means a trader can either:
- Buy those shares to enjoy the rapidly increasing price.
- Avoid the short squeeze by either closing their existing short position or not opening a new short position.
Short Interest
To identify a short squeeze before it happens, traders look at the short interest on a stock.
A stock’s short interest will be displayed on most trading platforms and stock trackers.
However, the short interest will always be displayed on the governing exchange’s stock tracker.
The short interest on a stock is measured in the percentage of the shares outstanding of a public company that are currently borrowed by short sellers.
The more of the outstanding shares are borrowed by short sellers, the higher the short interest is.
The higher the short interest on the shares outstanding, the more susceptible that share is to a short squeeze.
Generally, small-cap stocks with a small number of common stock will have the highest rates of short interest among outstanding stocks.
Price Increase Catalyst
Even if the short interest on a stock is extremely high, that does not guarantee a short squeeze will occur.
There must be an initial sudden increase that starts the squeeze effect on the short sellers.
Typically, positive news events such as quarterly earnings reports or press conferences are good opportunities for a rapid increase that starts the short squeeze.
The Best Tools for Trading Short Squeezes
Short squeezes are a great opportunity for retail investors of all levels of experience.
The basics of a short squeeze are easy to understand, but spotting them consistently takes experience.
Traders of all experience levels need cutting-edge stock market information trackers and stock screeners.
These tools allow traders to find critical information, such as short interest, as well as numerous supplemental metrics related to short squeezes, such as daily volume.
These market trackers also provide the most up-to-date information, allowing traders to spot price increase catalysts before anyone else.
Our top recommendations for market information trackers for retail traders are:
Trading short squeezes also requires brokerage platforms with a wide range of securities, a full suite of analytical tools and the lowest possible transaction costs.
Our top recommendations for brokerage platforms for retail traders are: