Short squeeze may lead to an unfortunate situation for many traders. Here's everything you need to know to not get trapped in it.
The definition of a short squeeze can be termed as the tension experienced by short sellers to cover their respective positions due to a sharp increase in stock prices. This condition occurs when asset prices rise sharply as many short sellers are forced out of their positions due to a sudden and sharp price increase. Short sellers usually assume that the price of an asset will fall only to be astounded when it reverted back in a short time.
For example, Investor A borrows 10 shares of Company Z at $5 per share. A few days later, Company Z's stock rises to $10 per share which means Investor A is losing $50.
The logic behind this is the short seller thinks that the company's stock price is too cheap or undervalued. But due to high demand, the stock price rises exponentially.
One notable example of a short squeeze is what happened to Volkswagen AG (VOW.DE) in 2008. It all began when Porsche planned to buy a large volume of Volkswagen stocks during a slow market due to the financial crisis. The transaction would leave out about 6% of Volkswagen's shares in the market, increasing the risk of being illiquid.
Traders who had already placed short positions were simultaneously vying to exit, thus creating a surge in demand for the remaining Volkswagen stocks. As a consequence, the price soared about 300% from below $40 to over $110 in a matter of days. But as we now know, Porsche's plan was not realized and Volkswagen's stock price slumped again. It was in fact Volkswagen that acquired Porsche 4 years later.
The incident ended up causing short sellers to lose billions. When many short sellers try to repurchase simultaneously, there is no limit to how high the stock price can rise. This often gives rise to opportunistic investors who try to take advantage of conditions by buying during rising prices.
Why Does Short Squeeze Happen?
The process behind a short squeeze may start when stock prices move in the opposite direction of investors' expectations leading to rapid price increases. When the price increases, the short position starts to lose. As a result, short sellers were forced to close their positions. Short sellers then realized that their position was unprofitable and tried to buy back the stock with minimal losses, causing a sharp price spike due to the high buying rate.
Fundamentally, the reasons why a short squeeze occurs are as follows:
- Minimum liquidity.
- Abnormal accumulation of short positions (short surplus).
- There is a fundamental report that goes against the initial trend of the price movement and suggests a reversal only to be proved fake later on.
Is Short Squeeze Illegal?
Anyone who knowingly allows a short squeeze to continue without taking action has the potential for serious legal entanglements.
According to the Securities and Exchange Commission, short selling is as illegal as the law states. This manipulative activity violates various securities laws, including Rule 10b-5 under the Exchange Act.
How to Anticipate Short Squeeze
Short squeezes are often done by a certain group of influential market players because they know many investors are short on this market. The result is a significant financial loss. Fortunately, some investors could try to anticipate an upcoming short squeeze by monitoring several leading indicators. One of the most important indicators is market sentiment. This method reveals the market's tendency toward a particular financial instrument. Here are two potential methods for assessing, timing, and interpreting possible signs of the impending short squeeze:
Short Interest Ratio
This ratio is simply a mathematical indicator that tells the average investor the number of days it takes a short seller to repurchase the borrowed stock. This ratio is the total number of shorting shares divided by the average daily trading volume. Let's assume that there are 10,000 short shares in Company A with an average daily trading volume of 1000. In this case, the short interest ratio will be equal to 10.
See also: Buy/Sell Ratio
If you are a short seller, to detect whether there is a short squeeze or not, you can compare the value of a company's short interest ratio in one period to several previous periods, generally during the last 30 trading days. If the value of this indicator is lower than usual, it means that the price is rising too fast or that many short sellers are closing positions because the stock price is considered too stable. On the other hand, if the value of the short interest ratio is higher than usual, the stock market will likely start to decline. However, if the increase in the value of the short interest ratio and the price is very sharp, then this could be a signal of a short squeeze.
Short Interest Percentage
The short interest percentage is the comparison between the number of short sellers in the company's stock and the total number of shares of the company. So, if there are 10,000 short sellers in Company A with 1,000,000 shares outstanding, then the short interest percentage rate is 1%. The higher the number, the harder it is for short sellers to repurchase the stock if the price goes up.
See Also: Is Stock CFD a Good Investment?
What to Do During a Short Squeeze?
As mentioned, a short squeeze can lead to huge financial losses. There are ways to avoid falling victim to a short squeeze:
1. Stop Loss
Stop loss is the level at which the position will be closed if the price reaches it. For example, if a stock is shorted at $10, a stop loss can be placed at $15 which means the position will be automatically closed at a loss of $5.
Stop loss itself means the trader limits their loss at a level they're capable of tolerating. They can determine how much loss they can bear when placing a stop loss.
If you are a short seller, don't be easily provoked when you see other people or groups succeed in selling a stock without any logical reason. Closing the position is the best way to avoid bigger losses.
Hedging is a strategy that can remove uncertainty in investing to a greater extent. In addition, this strategy can protect your profits and reduce losses in the event of a crash or price correction. For example, an order to buy a stock above $15 in the previous example would effectively serve as a stop loss.
Hedging may seem counterintuitive as it is essentially entering a position opposite to the current position. However, this strategy reduces the level of risk due to price movements that can harm traders when buying shares.
Not only in the stock market, but this strategy can also be used in other major financial markets. When applied with the right and proper techniques, hedging can protect your position against sudden movements that might be unfavorable.
It's no secret that a stock can experience a sharp price increase suddenly. The value of this change can be from hundreds to even thousands of dollars at once. Without the right strategy, an investor can suffer losses, even though they previously mapped the asset perfectly and opened a trade accordingly. Through hedging, a trader can use more than one position simultaneously in the opposite direction.
Stock buying is like an endless game of study so you have to always know what's going on behind the scenes to try and see moves like short squeezes that have happened before. In a way, several strategies need to be carried out during a short squeeze to minimize the risk of loss. No matter how much money you have, use only part of it to buy some stock assets.