What Is A Short Squeeze?
A short squeeze is a situation in which the price of a security is forced higher by a lack of supply created by buyers, who try to cover their short positions in the security. This usually occurs after a period of time in which the security has been in a bearish trend, whereby the price has been deteriorating as a result of investors having short positions in it. Additionally, a short squeeze can lead to an increase in panic buying, which in turn leads to a further rise in the security’s price.
Short Selling Basics
Short selling is the process by which an investor borrows a security from a broker and sells it on the open market. The investor has effectively sold the security hoping that the price of the security will go down before they have to buy it back and return it to the broker. If the security price goes down, then the investor can buy it back, return it to the broker and also keep the profit.
When Short Sellers Are Forced To Cover Their Positions
The downside of short selling is that it is a risky venture, because if the share price rises instead of falls, then the investor has to buy it back at a higher price than what they sold it for, resulting in the short seller taking a loss.
A short squeeze occurs when the price of a security suddenly increases, forcing all of the short sellers to cover their positions in order to avoid further losses. This can be difficult for short sellers if the security’s price continues to rise, as they have to buy to cover their position, pushing the price even higher.
Which Factors Trigger Short Squeezes?
There are several factors that can trigger a short squeeze, including:
- A Change in Company Profile
This usually occurs when a company publishes better-than-expected earnings results, declares a dividend, or announces a merger or acquisition. Such news is often taken positively by the market, resulting in a surge in the company’s share price, forcing short sellers to cover their positions.
- Excessive Shorts
When there is an excessive amount of short positions in a security, investors and traders seeking to exploit this can ignite a short squeeze by pushing the price higher. This can result in a snowball effect which causes other investors to buy in, thereby forcing the price up further.
- Short Interest Increase
When there is a rapid increase in the amount of short positions open in a security, this may cause investors to become wary of a potential short squeeze. This can attract additional buyers, who may try to buy in prior to the short squeeze developing, resulting in the short squeeze being further enforced.
- Releasing Positive News
The release of positive news, such as an increase in earnings or positive analyst coverage can quickly lead to a surge in the security’s price. If this happens while there was a wealth of short positions open, then it can be the trigger for a short squeeze occurring.
- Panic Buyers
This is usually the consequence of one of the other factors listed above. Panic buyers usually purchase in a security in order to take advantage of the surge in its price, which can cause a short squeeze to become even more intense.
Tactics To Avoid Getting Caught In Short Squeeze
- Monitor Opening Positions
Monitoring the short-interest ratio for a security is one of the most effective ways of avoiding getting caught in a short squeeze. This will give the investor a good indication of whether there are too many short positions open in the security, which can lead to a potential short squeeze occurring.
- Use Stop-Losses
Setting a loss limit on a security can be an effective way of avoiding losses in the event that a short squeeze occurs. If the price of the security rises above the loss limit, then the investor’s trade will be automatically closed, thus protecting them from taking further losses in the event of a short squeeze.
- Place Limit Orders
Placing limit orders gives the investor more control over the prices at which they buy and sell a security. This will reduce the investor’s exposure to losses, as they can set the limit orders slightly below the market’s price, therefore reducing the likelihood of the investor getting caught in a short squeeze.
- Be Warned By Volume & Price Movements
Be aware of any unusual volume or price movements in a security, as these can be potential signs of a short squeeze developing. Any sudden increase in the trading volume of a security may be indicative of investors buying in order to cover their short positions and capitalize on the potential profits from the short squeeze.
A short squeeze is a situation in which the price of a security is forced higher due to a lack of supply caused by short sellers trying to cover their positions. This is usually triggered by a change in company profile, excessive shorts, or the release of positive news. To avoid getting caught in a short squeeze, investors should monitor the short interest ratio and use limit orders, stop-losses, and be warned by volume and price movements.
