Understanding a Short Squeeze – How do investors profit from them?

short squeeze

The rallying of stocks occurs for a whole host of different reasons, including anticipated buy outs, positive earnings announcements, and other announcements that may be beneficial to the future of the company. The price of a stock can be quickly pushed up as a result of a short squeeze occurring. In order to profit from this process, and / or avoid having your stocks squeezed, you must first understand how to short sell, and how to spot the signs of a short squeeze. Understanding a short squeeze is definitely essential.

What exactly is short selling?

Investors in the stock market buy stocks in the hope of selling them at a later date at a price that is higher than what they bought them for. Selling short is the exact opposite of this. Investors sell the stocks first and hope to buy them back later at a lower price.

To successfully short a stock it needs to be loaned from the person that owns it.  Brokerage firms will do this for you providing the stock is actually shortable. It is possible for a short to be covered for either a profit or a loss. The further the price increases, the greater the loss as the price may go above what you sold it for. The further the price drops, the greater the profit. Providing the stock goes down to $0, the maximum amount of profit that can be made is what you initially receive from the short sale.

What is a short squeeze?

Short sells are typically made by those investors looking for short term to medium term profits, and so are not prepared to ride through the highly volatile market. Because of this the investors are extremely sensitive to price. Trades of shorts are taken on margin, so if the price of a stock goes up against the investor’s short position, they will need to put in more capital or become liquidated against the position.

These pressures cause lots of investors to worry and panic buy in order to cover their position. This movement away from short positions causes multiple purchases, along with the purchases that cause panic with the short position in the first place.

A short squeeze occurs when lots of short positions within a stock are pushed by investors into covering up their short position in the fear of making large losses. This acts to create a jump in the price of the stock. Short squeezes occur quickly on small daily moves. Because there are multiple factors that affect the price of a stock, it is not easy to predict when or where a short squeeze will occur.

How to make money from a short squeeze

Working out which stocks will experience a short squeeze is what is required in order to successfully trade them. To do so there are some certain criteria that investors may use in order to choose to pick the correct stocks. These criteria include:

The days to cover ratio – This is calculated by adding the entire number of short positions in shares and dividing it by the daily volume average. The higher the days to cover the greater potential risk for the shorts. As a result of their position being so high, it can not be simply exited without putting up the stock’s price and volume.

Percentage of float – This is the amount of shares that are short in relation to how many are available to be traded altogether.

Upon identifying a potential stock, there are two different ways that it can be traded. It is often the case that the stock’s trend will go down, explaining why many investors are short on it and expecting it to go even lower. When a short squeeze is looking like it is about to occur, buy short term trades in order to take advantage of what could be a potential increase in the stock’s price. These increases do not usually last very long because the stop loss orders on the short positions will be triggered.

Risky business

The process of attempting a short squeeze trade can be highly dangerous for many reasons. This is because of the many different factors that affect the price of a stock. It is also difficult to distinguish whether a rally of the stock is a normal one, or a short squeeze.

Stocks are typically weak if there is lots of interest in a short. In order to profit from a short squeeze you must buy a weak stock, which comes with its own set of risks. It is also difficult to accurately time when to purchase a short squeeze. The strong movement, which is a trigger of a short squeeze happens very fast so it is helpful for an investor to have a variety of stocks at their disposal, which they think are likely to short squeeze at any given time. They should also be aware of what factors could cause lots of buying of the stock.

Because a short squeeze is likely to make big movements in just a short space of time, there is a high potential for a quick profit. Shorting after a short squeeze has taken place, astute investors can buy the stock at a good price in order to take advantage of any further downward movement of the stock.

What to remember

To take advantage of a short squeeze position investors need to identify potential stocks to trade in. They also need to be ready to trade at any minute where there is panic with short sellers. An investor should only act one the stock’s price confirms their suspicions.

It should be noted that interest in a short being high does not necessarily mean the price of the stock will go up, and vice versa with lack of interest and the price of the stock going down. It is best to trade in whatever direction the stock trend is going in, using the short squeeze as a method of getting into it.

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