Is It Possible to Trade a Short Squeeze?

FXOpen

Understanding the dynamics of a short squeeze is essential for traders navigating the volatile terrains of financial markets. This phenomenon, where a sharp increase in an asset's price forces short sellers to cover their positions, can lead to dramatic market movements. In this article from FXOpen, we explore what triggers a short squeeze, how to identify potential candidates, and approaches for trading them effectively.

What Is a Short Squeeze?

A short squeeze occurs when a swift increase in an asset's price leads to significant losses for those who have traded against that asset by short selling. While short-selling stocks involves borrowing shares to sell them, aiming to buy them back at a lower price, it's important to note that in the context of CFDs (Contracts for Difference), traders are engaging in agreements to exchange the difference in the price of an asset from when the position is opened to when it is closed, without the need to physically borrow or deliver the actual securities.

If the price rises instead of falling, short sellers are compelled to buy back the shares at a higher price to close their positions and prevent further losses. This rush to buy back shares adds further upward pressure on the asset's price.

Short squeezes are most commonly associated with stocks, though they can occur in commodities and crypto* assets. However, given the complexities of determining how heavily a commodity or cryptocurrency* is shorted, we’ll focus on stocks in this article.

The mechanics of a short squeeze begin with a high number of short sellers targeting a specific stock. If an unexpected event or piece of news triggers a positive sentiment about the stock, its price starts to rise. As it climbs, short sellers start facing mounting losses. To mitigate these losses, they buy back the shares, further driving up the price. This cycle can create a feedback loop, where the buying pressure from closing short positions leads to further price increases, compelling even more short sellers to buy back at increasingly higher prices.

Short squeezes highlight the inherent risk of short selling, as the potential losses are unlimited. The price of an asset can theoretically rise infinitely, in stark contrast to buying shares, where the loss is limited to the initial investment should the asset's price fall to zero.

Identifying Short Squeeze Stocks

Identifying stocks that are prime candidates for a short squeeze involves analysing specific indicators that signal a stock may be under heavy short-selling pressure but poised for a rebound.

Downtrending Stocks

Traders usually start with stocks in a downtrend. These are stocks whose prices have been falling, attracting short sellers expecting further declines. A prolonged downtrend might indicate that a stock is oversold, setting the stage for a potential reversal if market sentiment shifts.

Short Interest

This metric indicates what portion of a company’s available shares are sold short. It can be found on sites like MarketWatch, Nasdaq, and Finviz. A high short interest percentage, particularly above 15%-30%, suggests that a significant number of investors are expecting a stock to decline. Such high levels can fuel a short squeeze as short sellers rush to cover their positions during a price uptick.

Days to Cover

Days to cover is the result of dividing the total amount of shares shorted by the average daily volume of the stock. Sources like Nasdaq, MarketBeat, and Fintel provide this data. A higher figure, such as three or more, indicates that it would take several days for short sellers to buy back and cover their positions, increasing the likelihood of a short squeeze during periods of heightened buying activity.

Approaches to Trading a Short Squeeze

Approaching a short squeeze requires understanding that due to the volatile and unpredictable nature of such events, it's challenging to outline a step-by-step, replicable short squeeze trading strategy. However, when a stock is identified as a potential short squeeze candidate, traders might look for specific signals indicating the stock may be poised for a rapid increase.

If you’d like to explore how indicators might be applied in a short squeeze scenario, consider using FXOpen’s free TickTrader platform to explore real-time charts.

Catalysts

Catalysts play a crucial role in triggering a short squeeze. These can include unexpected company news, significant shifts in social media sentiment, or surprising earnings reports.

Unexpected news is particularly potent. Social media trends and upcoming earnings reports might offer short sellers time to prepare, but sudden positive developments can start a scramble to close positions, thereby driving the stock price higher. In GameStop’s case, the squeeze was partially triggered by activist investor Ryan Cohen joining the board.

RSI (Relative Strength Index)

A stock with an RSI below 30 on a daily chart is considered oversold and may be ripe for a reversal. An RSI climbing back above 30 can be a sign that the stock’s price is beginning to recover, indicating potential buying pressure. Similarly, an RSI above 50 signals that bulls may be in control. The divergence between the stock price and RSI, where the stock makes new lows but the RSI does not, can further signal a weakening downward momentum.

Breakout on High Volume

A significant increase in trading volume, coupled with a strong price breakout, suggests that a short squeeze could be underway. This spike in volume indicates heightened buying interest, likely putting pressure on short sellers. As the stock price climbs and volume spikes, more traders may notice and join the buying frenzy, exacerbating the squeeze as shorts rush to cover their positions to minimise losses.

Moving Averages

Long-term moving averages, such as the 50 and 200 periods, are tools traders use to gauge a stock's momentum. A bullish crossover, where a shorter-term moving average crosses above a longer-term one, especially on the 4-hour to daily charts, can signal a potential uptrend beginning. If it occurs in the context of a potential short squeeze, it can similarly serve as a catalyst for further buying as traders anticipate other market participants to pile into the stock.

It’s important to note that none of these factors can be used in isolation to pinpoint a stock about to undergo a short squeeze. However, taking a holistic view and examining which fundamental and technical factors point to a potential rising stock price can help traders make a better-informed decision.

Short Squeeze Example: Bed Bath & Beyond

While the term ‘short squeeze’ ended up on traders’ radars after the infamous GameStop short squeeze of 2021, there have been others since. Let’s take a look at one from August 2022 in Bed Bath & Beyond (BBBY).

In 2021 and 2022, Bed Bath & Beyond became a focal point for WallStreetBets, the online community credited with initiating the GameStop short squeeze. It was branded as a so-called meme stock, along with others like AMC Entertainment and Blackberry.

According to TheStreet, the retailer boasted a short interest close to 40% around the start of August 2022. Likewise, days to cover were reported at 3.4 and 2.3 on July 15th and July 31st, respectively, as per MarketBeat.

Despite the broader rally among various meme stocks like GameStop and AMC between May and June, Bed Bath & Beyond had yet to see any significant movement and was gradually trending lower. There weren’t any significant catalysts to justify a rally; its earnings reported in late June were disappointing.

However, retail investors, primarily from WallStreetBets, began accumulating shares in early August, driving up its stock price. On Monday, August 8th, BBBY experienced a significant gap up, opening at $10.92 compared to the previous close of $8.16 on Friday, August 5th, marking the year's highest volume. Notably, this surge was preceded by a bullish divergence in the RSI.

The momentum continued, with the stock price reaching a peak of $30 on August 17th. This interestingly coincided with news of Ryan Cohen—a key figure in the GameStop short squeeze—planning to sell its 10% stake in Bed Bath & Beyond.

The significant short interest suggests that the rally was partly fueled by short sellers forced to cover their positions, a movement underscored by the increasing volume observed on the stock's chart.

Risk Management in a Short Squeeze

In managing risk during a short squeeze, keen observation of specific metrics such as short interest and days to cover is essential. Traders often watch for declining short interest or a decrease in days to cover, signalling that the squeeze might be nearing its end. Such changes can indicate that short sellers are closing their positions, potentially leading to reduced upward pressure on the stock price. Notably, in BBBY’s case, days to cover sank to 0.9 on August 15th, signalling waning squeeze momentum just before the peak.

Similarly, entering a short squeeze at the right time is crucial. As these events can attract widespread attention, they often become crowded trades. The fear of missing out (FOMO) drives many to jump in too late, making them vulnerable to significant losses if the stock reverses direction. It's important to be wary of entering trades purely based on momentum, as late participants are most at risk when the tide turns.

Finally, staying abreast of news and market sentiment is key. For instance, the GameStop (NYSE: GME) short squeeze saw a dramatic reversal from its peak when trading platforms like Robinhood restricted trading on GME.

In Bed Bath & Beyond’s case above, the peak came just as news broke of Ryan Cohen’s investment fund selling its stake in the company. It was a classic case of ‘sell the news’; the stock had already surged over 500% over the previous month, and many short sellers had likely exited their positions, evidenced by the steep drop in the days to cover metric. This implied further upside was limited.

The Bottom Line

Understanding and navigating the complexities of short squeezes can significantly impact stock trading strategies. By understanding what triggers a short squeeze, identifying potential targets, and applying strategic approaches to trading, individuals can better position themselves in the face of rapid market changes.

For those looking to delve deeper into the financial markets and take advantage of potential trading opportunities or hedge against such significant price spikes, consider opening an FXOpen account. We offer the tools and resources needed to navigate the markets with confidence.

FAQs

What Does Short Squeeze Mean?

A short squeeze occurs when an asset’s (usually stock) price rapidly increases, forcing short sellers to buy back assets to close their positions, further driving up the price.

What Is a Short Squeeze in Trading?

In trading, a short squeeze is when an asset's (usually stock) increasing price triggers short sellers to close sell orders, which amplifies the asset's upward movement.

How Does a Short Squeeze Work?

It begins with an asset (usually stock) experiencing a sudden increase in price. Short sellers, facing potential losses, rush to buy assets to exit their positions. This demand pushes the price even higher, possibly leading to more short sellers covering their positions.

How Long Does a Short Squeeze Last?

The duration of a short squeeze can vary from a few hours to several days or weeks, depending on factors like the volume of short interest and market sentiment.

What Causes a Short Squeeze?

Short squeezes are typically caused by an unexpected positive development for the asset, a sudden increase in demand for shares, or a combination of both, leading to a rapid price increase.

Is a Short Squeeze Illegal?

No, a short squeeze is not illegal. It's a market phenomenon driven by supply and demand dynamics. However, abusing short-sale practices with the intention to manipulate a market is illegal.

Who Started the GameStop Short Squeeze?

The GameStop short squeeze was initiated by retail investors, particularly those from the Reddit community WallStreetBets, who encouraged buying the stock to force a squeeze on short sellers.

*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.

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