It’s not easy trying to spot a potential short squeeze. Short squeezes can be the holy grail of market opportunities if you’re savvy, or your worst nightmare if you’re caught on the wrong side.
Here’s a look at how to spot potential short squeezes and how to avoid them all together.
WHAT IS A SHORT SQUEEZE?
A short squeeze is a stock market dynamic that can send shares of a stock dramatically higher in a short period of time—generally anywhere from a few hours to a few days.
Any stock is susceptible to a short squeeze, but those with low volume are especially vulnerable.
Squeezes occur when a stock with a large short interest (that is, a large percentage of shares are currently held by short sellers) begins to move higher. The catalyst for this initial move, if there is one, doesn’t really matter.
What does matter, is the move higher causes some short sellers, whether by choice or automatically, to begin covering their positions.
This begins a feedback loop, with the initial short covering driving the price higher, which then causes more shorts to cover, which then drives the price even higher, which then…you get the idea.
As buyers flood into the stock, the short sellers get “squeezed” out of their positions.
HOW TO SPOT SHORT SQUEEZES?
People can get caught on the wrong side of short squeezes because they can seemingly come out of nowhere. However, there are warning signs that one may occur if you know what to look for.
Stocks with large short interest are the most vulnerable to squeezes. Generally, a short interest of over 20% is considered a potential red flag. Tesla, one of the most popular stocks to short on Wall Street, has a short interest of around 27% at the time of this writing.
Any stock with a small number of shares available to trade—a low float—has the potential to be squeezed as well, as a sudden surge in volume can cause volatile swings in either direction.
If you see a stock rise sharply on high volume without news from the company or a technical formation, there’s a decent chance it’s a short squeeze. If this happens to a stock you’re in, it’s important to understand your options.
WHAT TO DO IF YOU GET CAUGHT IN A SHORT SQUEEZE?
Short squeezes tend to be short-term events, meaning the huge gains often only last a matter of hours, days or weeks. At the same time, there’s no way of knowing just how high a short-squeeze can carry a stock in the near-term.
The first thing to determine is whether you can afford it, both emotionally and in your margin account.
If you decide that you have enough in your margin account that you won’t be forced to cover, and can stomach some short-term pain, the only other thing to ask yourself is whether your fundamental thesis has changed. If not, the best move may be to wait it out.
If the short squeeze is overpowering you, set a stop loss if you don’t already have one. This will trigger a buy order that will get you out of the trade.
As a rule of thumb, you should never short a stock without first having an exit strategy and understanding your broker’s margin rules and requirements.
These types of trades are unpredictable hazards of the stock market, but recognizing when one is happening can potentially save you some money on your trade.