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Short squeeze in trading

A short squeeze happens when market prices rise beyond the predictions of market analysts, ‘squeezing’ traders out of the market. In this instance, they attempt to exit their trades as quickly as possible by selling their short positions. If it is not possible, short sellers are then forced to rebuy borrowed shares at an increased price and return them in order in order to cover their positions.

A short squeeze most commonly occurs within the stock market​, as prices can be particularly volatile and traders are able to ‘borrow’ stock. However, these can also occur in other financial markets, including short squeezes in bitcoin and forex trading. This article covers the meaning of a short squeeze, how to predict when a short squeeze is about to happen and how to reduce losses as much as possible.

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What is a short squeeze?

When there is a short squeeze in the stock market, traders often use short-selling strategies to open positions on shares that they think will decrease in price. Rather than attempting to profit from the bull market and company growth, instead, they look for negative market sentiments, known as trading the bear market. Read more about shorting stocks here.

Short interest refers to the total number of open short positions for a stock. Therefore, a short squeeze tends to occur in companies with a high level of short interest, such as Netflix or Tesla, of which the latter has topped NASDAQ’s list of most shorted stocks in the US for consecutive years. In the face of a short squeeze, short sellers should attempt to cover their short interest through buying actual shares of the company that they were betting against.

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What causes a short squeeze?

A short squeeze occurs when there is a sharp and unexpected change in price of a financial asset, usually caused by positive news release​ on a stock’s performance or if there is a higher demand. This will make short sellers want to abandon their positions, but in turn, this only increases the demand for stocks to rise and supply will reduce. The pressure to rebuy the stock and close their positions can be damaging to their trading portfolio, however, as they will spend a far higher figure than the original value of the positon in an attempt to close them.

Days to cover a short squeeze

Traders can use a ‘days to cover’ or short ratio to measure the number of days that are expected to close out a company’s shorted shares. This calculation is useful for predicting a potential short squeeze in the market. If there is a high days to cover or short interest ratio, then traders can go long (assume a buy position) on a company’s share ahead of the predicted event.

Days to cover = short interest (number of shorted shares) ÷ average daily volume

How to find short squeeze stocks

Searching for stocks that have potential for a short squeeze involves a screening process. This usually focuses on two aspects: a short interest of around 20% and over, and an average daily share volume of over 100,000. This means that the short interest ratio is likely to be higher. Small cap stocks with a market capitalisation of over $300m and a price over $5 is also preferable, so that they are not considered penny stocks. When short positions have grown above the short interest of 25%, especially if this happened rapidly, the likelihood of a short squeeze increases.

Traders often decide to use technical indicators to help them with the screening process. Short squeeze indicators focus on finding oversold and overbought stocks, as traders will expect their price to rise. Two popular indicators used to identify a short squeeze are the relative strength index (RSI) and stochastic oscillator, both of which are available on our online trading platform, Next Generation.

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Short squeeze examples

Electric vehicle company Tesla is often the subject of short squeezes among traders. In October 2019, Tesla’s share price increased by nearly 30% after the release of a positive earnings report. This cost short sellers a combined loss of around $1.5bn from those who had been betting against the stock price to fall.

GameStop short squeeze

In January 2021, American video game and electronics retailer GameStop encountered a short squeeze that had a significant impact on its short sellers. GameStop's share price​ had declined in value over recent years, due to competition from more prominent online distributors, leading to approximately 140% of GameStop's public shares being sold short. A multitude of retail investors decided to start buying shares in order to increase its value, causing a scramble for existing short sellers to cover their positions and buy back the stock at a significantly higher value - almost 200 times the original amount. This meant that short sellers and large corporations such as hedge funds experienced sizeable losses. GameStop is an example of a meme stock​, which are often the targets of a short squeeze.

Historical short squeeze

An example of a notable historical short squeeze involves the German car manufacturer Volkswagen, in October 2008. Following the financial crisis, the stock price was slowly going down, while the level of short interest was growing rapidly. However, a news release revealed that Porsche was investing into the majority of Volkswagen’s shares, leading its share price to soar by 146%. This led to a reduction in available stock, and short sellers who had been betting on the stock price to fall raced to close their positions and buy up any stock left in order to cut their losses. As a result, Volkswagen briefly claimed the title of the company with the largest market capitalisation in the world.

What are the risks of a short squeeze?

Trading on a short squeeze can bring an extremely high level of risk for short sellers. If they are not able to short sell their shares, there is no guarantee how high a share price will rise after a fundamental event. Therefore, traders may be forced to buy more stocks at double the original value, or even higher. When trading with leverage, this magnifies the extent of losses. These risks should always be taken into consideration when spread betting or trading CFDs on the share market. Consult our money and risk management guide​ for more information on stop-loss orders and other risk management tools.

Practise your short squeeze strategy

In order to trade short squeezes, you should do thorough research on the share market beforehand. One strategy for trading on a short squeeze is to go long on (or buy) the asset that is set to rise in share price; however, different strategies will work for different trading personalities or overall goals.

Trading a short squeeze is possible through our derivative products such as spread bets and CFDs. With derivatives, you do not actually own the underlying share, but rather speculate on its price movements. With traditional share trading, you are required to purchase and take ownership of the stock, whereas leveraged products give traders the advantage of placing a small deposit of the full value and receiving full exposure to the market. However, margin trading​ comes at a high risk and losses can surpass profits just as quickly.

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Summary

Overall, a short squeeze can cause great losses for those who are short selling borrowed shares, or have betted against the price of an instrument that has recently increased in value. However, it can also cause great profits for traders who have identified short squeeze possibilities and subsequently opened a long position to take advantage of the market. This is part of an effective short squeeze strategy and can be done by traders of all experience levels, as long as you build an efficient trading plan​.

Disclaimer: 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.

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