As you get started in the world of investing, you may realize that it’s not quite what you thought it was. You’ve heard the stories of those who got rich in the market, of the massive runs in value that stocks can experience, and that making the right moves can lead to quick wealth.
Then you dive in.
You quickly realize that investing is a long-term game. You’re not likely to realize 100% gains in a single year. That takes years of compounding gains to achieve, doesn’t it?
There are some events that take place in the market that can lead to triple-digit gains over a very short period of time. However, the strategies surrounding them are often riddled with risk, and the potential losses can be just as big. One of the still risky, yet safer, events to try to work into your investing or trading strategy is known as the short squeeze.
Short squeezes take place almost every day. They lead to dramatic gains in value before reaching a point of resistance, where the stock falls down to a more realistic price. Nonetheless, timing trades just right in the midst of a short squeeze can prove to be an incredibly lucrative endeavor.
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What Is Short Selling?
In order to understand what a short squeeze is, it’s important that you know how short selling works.
When an investor is short in the stock market, it means the investor is betting the value of the stock will fall, rather than grow, over time. The most common ways to turn one of these types of bets into a profit is through a process known as short selling.
Essentially, a trusted broker charges a fee to borrow shares from long investors — investors who believe that the value of the stock will grow. These shares are then immediately sold in the open market by the short seller to the first investor willing to buy them.
If the price of the stock falls, the short seller repurchases the shares at the new lower price, and returns these borrowed shares to the broker. By selling when prices were high, and buying the shares back later at a lower rate, the difference between the two prices — minus any broker commissions — becomes a profit to the short seller.
Of course, just like long investing, short sellers can lose money. If the price of a shorted stock moves up, the short seller still has to return shares. Oftentimes, this means that they will have to pay more than the price at which they sold, in which case, the premium to the original price plus broker commissions becomes the short seller’s loss. Ultimately, the risk of this outcome is what leads to a short squeeze.
What Is a Short Squeeze?
A short squeeze is an event that takes place when a heavily shorted stock starts to realize gains. When this happens, all of the investors who are short on the stock start to lose money, and no one likes losses.
As the stock price rises and losses for short sellers expand, those who are short on the stock race to cover their positions. This means buying the shares that must be returned to the broker that borrowed them from long accounts.
The short covering action ultimately leads to more gains. After all, as shares are repurchased, the price of the stock moves up. In a relatively short period of time, it seems as though anyone who has a short position in the stock starts buying shares, leading to more trading volume and more gains.
Until all short sellers who are going to cover their positions do so, the gains continue. Oftentimes, the gains in a short squeeze are dramatic, ranging from 10% to more than 100% in a single day. This is far above what the average investment in a stock or group of stocks would return over the course of a couple of years.
Just as fast as the short squeeze leads to gains, however, it ends — and when it does, the stock falls dramatically. At this point, all short sellers have covered their positions and the price of the stock is considered to be highly overvalued.
As such, those who own the stock may sell shares to take profits and wait until the stock falls to levels that reflect what the overwhelming majority of investors believe to be its fair market value.
Key Factors to Consider
The above may seem like a lot to take in. However, if you keep the four key factors of a short squeeze in mind, you’ll be in good shape. For an event like this to take place, the following must be true:
- High Short Interest. In order for a short squeeze event to take place, a stock must experience high levels of short interest, often expressed as a “percentage of float,” or the percentage of a company’s publicly available stock that has been shorted by other traders. A high level of short interest is when the short percentage of the float is 10% or higher. In most cases, when investors look for short squeeze opportunities, they look for extremely high short interest — a short percentage of the float of 20% or more.
- A Catalyst. Before a short squeeze takes place, a catalyst must happen that leads the price of the stock upward. This can be a fundamental catalyst like a product launch, change in management, or a slew of other fundamental factors that can lead to gains. The catalyst can also be a technical catalyst like the value of the stock falling to support or some other technical signal leading to traders purchasing shares and sending the price of the stock higher.
- Short Coverage. The gains due to the catalyst must be significant enough to cause short sellers to race to cover their positions. In some cases, this may be gains as small as 1% or 2%. In others, a short squeeze may not be triggered until gains of 5% or more are realized in the value of the stock.
- Short Squeezes Happen Fast. Finally, a short squeeze doesn’t take place over the course of months or years. Most happen over the course of between one and three trading sessions. So, if you’re going to play the short squeeze game, be prepared to act quickly as the squeeze takes place.
How to Predict a Coming Short Squeeze
There is no way to predict the future with 100% accuracy. The weather man gets it wrong, doctors get it wrong, and traders will get it wrong here and there too. So, if you’re looking for a crystal ball to show you where the riches are, give it up — it doesn’t exist.
Nonetheless, with a bit of research your chances of landing on a short squeeze can be greatly enhanced. Here are a few steps that you can take to improve your odds of finding one of these needles in the figurative haystack that is the stock market.
1. Find Heavily Shorted Stocks
In order for a short squeeze to take place, the underlying stock must be heavily shorted. So, finding heavily shorted stocks is a great place to start. There are several tools available online that paint a treasure map showing where you can find potential short squeezes. Unfortunately, the vast majority of investor tools are paid subscriptions with exorbitant prices.
Nonetheless, there is one powerful tool, known as High Short Interest, that does just what its name suggests. The website provides a comprehensive list of the most heavily shorted stocks in the stock market. This list will give you all the leads that you need in order to hone in on the next big short squeeze.
2. Find a Coming Catalyst
In order for short sellers to run for cover, the stock has to move up. This only tends to happen when a catalyst takes place. Predicting technical catalysts is a bit of an artform best left to be described in another article. For this strategy, we’ll focus on watching for fundamental catalysts, as these are much easier for beginners to spot.
Start by going through press releases. To do so, go to Yahoo! Finance, and type the ticker for the stock you’re researching into the search bar. Once the quote page of the stock loads, scroll down below the technical data and click the “Press Releases” link. This will weed out the opinion articles and let you get right into what the company has announced lately. Read through press releases to look for catalysts that are expected.
For example, let’s say that the heavily shorted stock that you’re following is a biotechnology stock that’s developing a new drug for Alzheimer’s disease. In a quarterly-report-related press release, you read that results from a clinical trial are expected in a certain period. Sometimes, companies will give ranges of months, and sometimes they’ll give ranges of quarters. Nonetheless, write the timeline down on your calendar.
Scheduled events like this in other sectors happen all the time as well. A technology company may hold a summit where they will unveil a new product. An oil and gas company may be expected to complete the drilling of a new well in a predetermined period of time. An entertainment company may be releasing a new movie. All of these events have the potential to move the value of the underlying stock.
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3. Research the Coming Catalyst
The time between when you learn of a coming event and when that event is expected to take place is when the real research starts. During this time, do all of the digging that you can into the coming event.
If it’s a health care company with a data release coming, look into previous clinical studies, preliminary results press releases, and other types of data to form your opinion of whether or not results will be positive. If so, you have a positive catalyst to look forward to. If not, a short squeeze is not likely and you should move on to the next heavily shorted stock on your list.
No matter what sector the stock is in or what the event might be, the key here is doing enough research to build a well-informed opinion of what is likely to happen when the event takes place. When the new product is unveiled, what is it likely to be? When the new well is drilled, do you believe the company will strike oil? Is the movie release going to be a success, or will it fail at the box office? These are the types of questions this research is intended to answer.
Again, it cannot be emphasized enough that no one can predict the future. All signs may point to positive clinical trial results in Alzheimer’s patients, an awesome product on the horizon, oil in the well, or a great movie. That doesn’t mean that any of these outcomes are going to be the case. Nonetheless, investing is about informed decision making, increasing your chances of predicting the future.
4. Trust Your Research and Make Your Move
Emotion is one of the biggest issues among beginner investors. Don’t allow your emotion to get in the way of a research-driven decision to move. When the time period in which your catalytic event is scheduled to take place begins, buy the stock. The amount of stock is completely up to you. Just keep in mind that you should never invest more than you can afford to lose.
Now it’s time to hurry up and wait. While you wait for the event to take place, keep a close eye on the news from the company. Any delay of a scheduled big event can trigger losses. So, always pay close attention to what’s going on and be prepared to exit your position if the circumstances change.
5. Track the Squeeze
If your sound research leads to a positive catalyst, a short squeeze is likely. Nonetheless, this is not a set-it-and-forget-it strategy. The fast paced nature of squeezes means that if you forget to check on your stock for a single morning, you could miss the event entirely.
Once the short squeeze takes place, watch the movement of the stock very closely. You want to hold on and enjoy the ride for as long as you can, but it’s important not to get greedy. Throughout the squeeze, the stock will have short pauses from rapid upward movement where traders take profits leading to declines from highs. If these short periods last for any longer than 10 minutes, you could be reaching the top of the squeeze. It’s time to sell and enjoy your profits.
In some cases, short squeezes can take extended breaks and reverse back to the top as stragglers with short positions realize what’s happening. Don’t get sucked into these rapid movements upward, as they are often followed by rapid, unpredictable movement downward. By the time you see them, the window to make profits from them will likely have passed. Nonetheless, if you sell at the right time, the gains have the potential to be tremendous.
Always Consider the Risk
Any investment you make comes with some risk. However, some investing and trading strategies come with higher risk than others. In general, if the potential reward is high, you can expect the move to come with high risk. This is true when it comes to chasing the short squeeze.
There are several risks to consider when employing this strategy. The most important of these include:
- Heavily Shorted Stocks Aren’t Good Investments. Heavily shorted stocks are heavily shorted for a reason. The overall opinion in the investing community is that the value of the stock is going to fall. Buying shares in stocks like these is asking for losses if a positive catalyst does not take place.
- This Strategy Is Highly Speculative. While this strategy involves quite a bit of research, there is no way to determine if a catalyst is going to be positive or negative. If the catalyst is negative and you own shares, you’re in for a very bad day. Stocks that have the potential for a short squeeze often have the potential to generate losses of 10% or more in a single trading session if things go wrong. The highly speculative nature of this strategy makes for a risky play.
- Greed Can Get in the Way. Even when things seem to be going right, greed can become a major risk in and of itself. In many cases, after a short squeeze takes place, the stock will fall rapidly back to or below where it started. Being unwilling to accept gains when you should could lead you to chase the stock back down to where it started, or worse — into the red. Don’t get greedy; if you gain 10%, 20%, or even 50%, you’re doing better than most people do in a year. Time your exit wisely and avoid being greedy to ensure you don’t lose everything you may have gained.
- You Must Move Quickly. Most people simply don’t have the ability to track what’s happening in a stock minute-by-minute while the market is open. Due to the fast-paced nature of the short squeeze, an inability to act quickly could result in losses. So, this strategy takes a serious time commitment.
The first lesson that you should take from this article is that this is not a get-rich-quick scheme. Finding a short squeeze before it happens takes a lot of research, and, if you’re wrong, you could experience significant losses as you wait for an event to take place that ultimately doesn’t occur. Short-squeeze trading is not for the faint of heart or the risk-averse investor.
Nonetheless, the potential gains that can be experienced in these events are hard to ignore. Even the best investors hope for gains of 10% to 15% per year. To achieve that or more in a day is a game changer.
If you decide to get involved in the race to find the next big short squeeze, make sure to do your research. An informed decision is the difference between being right 70% to 80% of the time and being right less than 50% of the time.