Short Squeezes

Short Squeezes: What Are They And How Do They Happen?

The short squeeze is a market phenomenon that can affect online share trading. This happens when a stock's price unexpectedly rises, causing problems for traders who predicted it would go down. Thus, due to increased buying pressure, these short sellers are forced to buy the stock at a higher price in order to cover their positions.

Moreover, this situation can cause short sellers to lose money. However, it can be predicted and navigated with technical indicators like short interest and days to cover.

In this article, we will explore how short squeezes work, the factors that trigger them and online share trading considerations. Furthermore, we will discuss how online share traders can benefit from it.

Start Your Stock Market
Journey Now!

50 Years Trust |₹0 AMC |₹0 Brokerage *

Table of Content

  1. Short Squeezes: What Are They And How Do They Happen?
  2. What is Short Squeeze?
  3. How Do Short Squeezes Happen?
  4. Things to Consider When Trading
  5. Short Squeeze Trading Risk
  6. Benefits of Short Squeeze for Investors
  7. Conclusion

What is Short Squeeze?

A short squeeze occurs when the stock price increases unexpectedly. This situation negatively impacts short sellers, who have to buy stocks at higher prices to cover their short positions. As a result, the buying pressure in the market increases, causing the prices to rise further. 

There is usually a loss for short-sellers when they are squeezed out of their short positions. However, a number of technical indicators can provide traders with clues about short squeezing, including short interest, days to cover, and Relative Strength Index (RSI). 

How Do Short Squeezes Happen?

Imagine a stock that has a lot of short sellers. If the price of the stock rises by a big margin, this short seller may panic because they know they'll lose money. 

Now, let’s say you identify stock with an unusual number of shorts. It means they borrowed these stocks from someone else and are legally liable to repay them, even if they lose money. Since there are so many short-sellers, they're all betting the price will go down and make money.

Whenever anything causes the stock to rise in price, there's a chain reaction that creates such a condition. Additionally, when the buying volume is higher than the selling volume, a stock's price rises further.

As the price of the stock rises, short-sellers panic and buy the shares they've already sold back to cut their losses. With so many short-sellers already, the heavy buying increases the buying volume, and the security price goes up. As short-sellers buy stocks in a panic, the price goes up and continues till short-sellers stop buying stocks. Thus, it's always panic buying by short-sellers that leads to this condition in the financial market. 

Things to Consider When Trading

As a trader, the first thing you need to consider is the 'short percentage of the float'. This is the percentage of stocks available for trading that are shorted.

An ideal short percentage of the float is above 10%. It is only then that the security qualifies for a short squeeze due to heavy short interest. In general, the higher the 'short percentage of the float', the higher the chances of a short squeeze.

The 'short ratio' or 'days to cover' is also important to consider when trading. It is the number of days needed to generate enough trading volume to buy back all short-sold securities. Additionally, there should be a 'short ratio' of at least ten days. If there are more than ten days, it can be an indication that the security is overcrowded. In general, identifying the "short ratio" will help you avoid trades unless you want to get squeezed.

Short Squeeze Trading Risk

Short squeezes are rare phenomena, which makes them risky as well. In the past, prices have risen when they had an unusual number of short positions attached to them. In spite of this, there have been examples that failed even when there were unusually high short positions attached. Therefore, if you want to trade, you need to be extremely cautious. 

The presence of heavy short interest does not necessarily mean that the price of a security will rise. Also, it is crucial to understand that short-sellers do extensive research before initiating a short trade. Moreover, if you want to trade, you must have other indications that the security price is going up.

Benefits of Short Squeeze for Investors

  • There is no doubt that short squeezes are volatile and not for the faint-hearted. However, it's interesting to note that there's no theoretical limit on how high a stock can go, which can work out exceptionally well for some investors.
  • Taking advantage of this trading depends on timing and a little luck since no one can predict when one will occur. Short interest percentages are a good predictor of whether a rally is likely: the higher the short interest percentage, the more likely the rally will be. The same applies to short-interest ratios.

As soon as the situation is over, the stock price will fall, so timing is absolutely crucial if you want to make money from it. Moreover, as stocks can turn that quickly, you cannot lose focus here. You need to be on top of things every minute if not every second. Also, without proper research, it's somewhat like gambling and involves significant capital risk.

Conclusion

Online share trading can be seriously affected by a short squeeze. When a stock's price rises unexpectedly, it causes problems for traders who predicted a decrease. Due to increased buying pressure, short sellers cover their positions by buying the stock at higher prices. 

Additionally, it is important to do comprehensive research on a stock before starting a short trade. Contrarian investors can take advantage of this market condition if they discover an asset with high short interest. Although this trading can be profitable, it is usually recommended to trade them only after thoroughly assessing the security's technical or fundamental aspects.

Short Squeeze FAQs

It is bad news for short-sellers and good news for long-term investors.

As the stock price rises, contrarian investors who built up long positions in the stock will benefit.

It can last anywhere from a few days to a few months, depending on how much stock has been shorted.


 

There's no theoretical limit to how high a short squeeze can go.

Yes, short squeezes are risky.