Learn How to Spot a Short Squeeze

As GameStop’s shares jumped almost 18 times within 16 days in January 2021, short sellers lost about $6 billion due to their failure to recognise the short squeeze in time. The Guardian newspaper in the UK even went as far as saying that the 2021 short squeeze was a form of wealth transfer, as those who had invested only a few hundred dollars were the winners in this case .

Before GameStop grabbed the headlines, even many experienced traders were not aware of the short squeeze phenomenon. While such a record-breaking, headline smashing short squeeze may not occur too often, there’s one lesson traders should not forget – they must know how to spot a short squeeze. Depending on the direction in which a trader has positions open, short squeezes can translate into a meaningful opportunity or indicate when it’s time to exit quickly to curtail losses. Here’s a look at some techniques for identifying and trading a short squeeze.

1. What is a Short Squeeze?

Shorters typically hold onto assets that are trending down, till there are signs of a reversal. No stop loss gets triggered as long as the market moves in the predicted direction. At times, large shorters sell a declining asset with the hope of pushing its price down even further. This usually works. But when it backfires, and the price begins to rise steeply, it creates a phenomenon known as Short Squeeze.

2. What’s Behind the Scenes?

Short sellers speculate on a downtrend in the market. When prices start rising steeply, they panic and begin buying the asset in hopes of closing their positions and limiting their losses. As they buy the asset, its price rises further. Moreover, rising prices attract new buyers too. In a short span of time, demand surpasses supply, and the buying pressure causes prices to spike.

3. Why Does a Short Squeeze Occur?

There could be many reasons for an unexpected price pump, such as a positive outlook, an unexpected earnings beat, an M&A announcement, the huge success of a new product, pump and dump schemes, and heavy institutional investments.

Contrarian investors look ahead of short sellers by identifying the signs of a potential short squeeze and buy the asset with ‘high short interest’. This is a risky move because short sellers would have done their homework too.

What matters to traders is the disagreement between sellers and contrarians that exerts upward pressure on the price. Seasoned traders aim to identify a potential short squeeze early, just before the momentum picks up, as this results in meaningful profits within minutes. The goal is to buy and catch the squeeze before the price soars and they miss out on significant profits from the actions of panicked shorters. Buying at the end of a squeeze can result in outsized losses.

4. Identifying a Short Squeeze Before It Happens

Traders often look for assets with high short interest. This alone does not guarantee a short squeeze. Here are some ways to predict a short squeeze brewing:

A. Short Interest Percentage (SI)

SI% is the number of shorted shares divided by the number of outstanding shares. A high percentage means there will be greater competition during the squeeze and demand will push prices even higher.

B. Short Interest Ratio (SIR)

SIR is the ratio of the number of shares shorted to the average daily trading volume (ADTV). It reveals how long it will take for sellers to buy back the asset. It is also called Days to Cover.

C. Daily Moving Average Charts

A daily MA chart of 50 days or more helps locate if there were any peaks during the downward price movement, signalling the potential for the price to start reversing. It is essential to know the reasons for those peaks and keep an eye on the news to predict a short squeeze effectively.

D. Relative Strength Indicator (RSI)

RSI is a key indicator for identifying oversold and overbought conditions. If RSI is below 30, the asset is oversold, and traders can start looking for predictors of a short squeeze.

4. Signs of a Short Squeeze

Some factors lend weight to the above numbers in predicting a short squeeze. Together they increase the probability of a short squeeze. These are:

• An asset trading near its 52-week lows and the price is much lower than the fair value estimated by experts. The reasons for the gap may be many, but markets eventually correct and settle closer to the fair value. This is the minimum short squeeze price.
• While following assets with shorting interest (SI) over 20%, seasoned traders look for those that are above 50% and their fundamental analysis shows that the market does not fully appreciate the positives.
• Experienced traders also keep an eye on the borrowing cost of assets. A sudden drop in borrowing costs and an uptick in prices could indicate a large ‘shorter’ has begun to recover losses, and panic may soon start building up.
• An upcoming announcement from the company, a general body meeting, a new product release, and similar news events act as catalysts of price action. Keeping an eye on such events helps when planning a squeeze.

Key Takeaways

• A short squeeze occurs when short sellers start panic buying.
• Identifying a short squeeze early is key to making profits from it. Buying at the end of a squeeze can result in losses.
• Traders keep an eye on the short interest percentage and the short interest ratio, and combine these with the RSI and MA indicators to identify a potential short squeeze.
• Looking for signs in the market for the price to reverse is important to strengthen the short squeeze strategy.

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