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The guide to short squeezes and how to trade them

Short squeezes – when a sharp increase in the price of a beaten-down stock is accelerated by short-sellers closing their position – present a unique opportunity for traders. How can a short squeeze be spotted, and what are the risks?
 
After weathering the financial crisis and maintaining growth, by mid-October 2008 Volkswagen [VOW] stock was finally on the way down. With the price sliding more than 46% over the course of a week, the level of short interest grew rapidly. 
 
But then something that few expected happened. On the 27 October, the German car-maker stock gained 146%, making it the biggest company in the world by market cap. The reason? The revelation that Porsche SE had been buying up the stock sent the price rallying, and led to a rapid fall in available stock, more than 12% of which was reportedly loaned out for short positions. It resulted in the “mother of all short squeezes” as those betting against the stock raced to close their positions by buying up any available stock. The price skyrocketed. 
 

146%

VW's share price gain on 27 October

For those who owned the stock or had recognized the potential of a demand-driven short squeeze, this was a good day. While the case is perhaps an extreme example, due to the influence of Porsche’s buying spree, of the power of a short squeeze.
 
Other recent examples include numerous Tesla [TSLA] short-squeezes, which have helped trigger inflated gains and cost short-sellers billions. Most recently, on 24 and 25 October, as much as $1.5bn was lost when the stock, aided by a small short squeeze, increased nearly 30% following a positive earnings report. Match Group [MTCH], Netflix [NFLX] and First Solar [FSLR] have all been the subject of short squeezes in recent years.
 
 
 
So how can such opportunities be spotted?
 
A basic way to look for stocks with potential for a squeeze includes screening for short positions over 25% and an average daily volume of over 100,000. Looking for stocks that are considered to be small-cap or larger (generally considered to have above $300m market-cap), while a price over $5 (so as not to be considered penny stocks) is also preferable. Stocks with lower market caps and fewer publicly traded shares available are more susceptible to a short squeeze. 
 
Short interest is of course key to the possibility of a short squeeze set-up. Without the shorts, a squeeze cannot happen. When short positions have grown above one quarter, the likelihood of a short squeeze is greatly increased, particularly if short interest moves above the 25% level, or if interest has grown rapidly. The chances are that there are no more bears around to jump in and keep betting against the stock to help push it down, if there’s a turn to the upside. 
 

25%

Short interest threshold to look for

However, it is also important to consider the normal short interest in a stock. The short interest ratio (the number of days it’s likely to take shorts to cover their positions), is calculated by dividing the number of shorted shares by the average daily volume) to move higher.
 
 
Maintaining perspective
 
While a stock may fit the criteria for a squeeze, this doesn’t mean a short squeeze is inevitable. The stock could easily keep heading downwards.
 
Things to look out for include a turnaround in the fundamentals, a strong earnings report that goes against the narrative (think Tesla), negative sentiment towards a wider industry (think cannabis), a leading stock with good fundamentals being beaten down, or a technical pattern that shows a stock could be bottoming out, such as a tweezer bottom. 
 
 
Timing is also key and risk must be managed. While short squeezes can often occur due to a positive earnings report, buying a stock just before earnings is a risky endeavor as there’s a strong chance of the move going against you. Being poised to react as soon as the earnings are out is therefore preferable. 
 
It’s also worth noting that a short squeeze is an artificial boost to a stock’s value, so more often than not, the stock will soon revert to some extent. Volkswagen spent just one day as the world’s most expensive company. In the week following the initial spike, the stock had fallen back by around 25% to €393.00. By the end of the year, the share price had returned almost to the level at which the initial squeeze was triggered, where it remained for many months before dropping lower.
 
In short … traders looking to spot opportunities should screen for stocks that meet the short squeeze criteria and then wait for a shift in sentiment, fundamentals or a chart that could indicate the stock will move higher. But be aware, the pop is unlikely to hold for long so make sure to exit before the short squeeze becomes a long crush.

Disclaimer Past performance is not a reliable indicator of future results.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

*Tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK.

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