Chapter 6-5 Short Squeeze

Short selling is a strategy that attempts to capitalize on a decline in share value by selling stock at a high level and later repurchasing the security at a lower price.  The short seller benefits by selling high and buying lower.  It should be noted now that once a stock has been sold short; those sellers represent future demand because they must buy the stock back at some future date.  The appeal of selling short is easy to understand, as we’ve seen in years past just how fast stocks can fall.  Of course, as with any strategy that is a straight directional bet, there are risks involved.  The biggest risk to a short seller is that instead of share price dropping, the stock price rises.  We will see later that a rising share price in a stock that is heavily shorted can often lead to dramatic upward movement those short are forced to quickly buy the stock back.  The motivation to buy back the stock by the short seller is often the fear of unlimited losses.  When you buy a stock at $50 a share, the most you can lose is your entire investment is $50 a share.  When you sell a stock short at $50, the potential for losses, in theory, is unlimited.  The stock may rise to $100, which would result in a 100% loss of capital, but what prevents that stock from rising to $200, $400, or even $600? It is the fear of such an advance that can make for an explosive upside in a heavily shorted stock.  The phenomenon of a rapidly rising stock with a large short interest is known as a short squeeze.

 

In finance, a short squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and an excess of demand for the stock.  Short squeezes result when short sellers cover their positions on a stock.  This can occur if the price has risen to a point where short sellers must make margin calls, or more loosely if short sellers simply decide to cut their losses and get out.  (This can happen in an automated manner for example if the short sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock’s price, which in turn may trigger additional margin calls and short covering.  This type of frantic short covering can and does occur in other traded instruments as well, such as commodities and futures contracts.

Short squeezes are more likely to occur in stocks with small market capitalization and small floats, although can involve large stocks and billions of dollars, as happened in October 2008 when a short squeeze temporarily drove the shares of Volkswagen on the Frankfurt Stock Exchange from 210.85 euros to over 1,000 euros in less than two days, briefly making it the most valuable company in the world.

Before we continue, let us first cover some terminology that we will need to provide a deeper understanding of this event.

Short interest is defined as the total number of shares of a stock that has been sold short and not yet covered.  When a person sells a stock short, exchange rules mandate that the order must be identified as a short sale, with statistics on the total number of shares sold short kept by the exchange and released to the public once per month.  Short interest for NASDAQ stocks is tallied up by the exchange on the 15th of each month, and that information is disseminated to the public eight business days later.  For example, if the short interest is 1,500,000 shares as of August 15th, that information is released to the public on August 27th.  Any changes to this number are released one month later. The Short Interest Ratio (S.I.R.) is the number of shares sold short (short interest) divided by the average daily volume for the previous month for the particular stock.  This number is interpreted as the number of days it would take to cover (buy back) the shares sold short based on the average daily volume.  The higher the ratio, the longer it would take to buy back borrowed shares.  This often leads to upward momentum for the stock if the sellers became motivated to buy back their short positions.  If the stock had a short position of 3,000,000 shares and an average daily volume of 1,000,000, the S.I.R. would be 3.0, meaning it would take 3 full days of average daily volume for the short sellers to cover their bearish bet.  If the stock had an average daily volume of just 300,000 shares, the S.I.R. would then be 10.0, meaning it would take 10 days of buying to cover their position.  From a contrarian standpoint, a higher S.I.R is desirable because it means it is more difficult to cover the position, and thus the resulting buys have the potential to create significant short term trading profits.

Typically any number above 5.0 days to cover is considered a high number.  This information is a good starting point for finding potential short squeeze candidates because it gives us the answer of who would buy the stock.  By recognizing the large short position, we can understand the potential urgency buyers may have, which in turn could be a key psychological development behind a buying frenzy in the stock.

In order to whittle the list down further, the stocks charts should be studied to see if there is any technical indication that it might be the proper time for a low risk entry into the stock.  Any stock in a downtrend can be immediately eliminated because short sellers are more confident in a position that is moving in their favor.  Eliminating situations that are not high probability candidates frees our time to focus on the strong stocks where the short sellers may be in trouble.  If a stock is at a new high, it indicates the only source of supply will come from profit takers, rather than people selling to get even on a position they may have been holding in their portfolios at a loss.  A stock trading at a new high also indicates it is unlikely that the short sellers are in a profitable position and that may make them more motivated to cover their short position.  After we find a stock with a large short position that is losing money in a stock at new highs it is important to know the approximate price that the short position was initiated.  By understanding how much the short sellers are losing helps shed light on when they may become forced to cover.

It is important to know that a large short interest ratio by itself is not a reason for buying a stock in anticipation of a short squeeze.  As with any other indicator, the short interest ratio should not be used on a stand-alone basis.  The informed trader will find an edge when there is a preponderance of indicators leading to a price advance.  Short sellers who take large positions are typically sophisticated speculators who have done extensive research on their targeted company and are often right.  Many times those who sell short have the right idea fundamentally (examples include names such as Rambus, Presstek, and Krispy Kreme), but their timing could be off.  The correct time to sell a stock short is when it is either in, or entering, a downtrend.  When a short position is initiated in a stock that is trending higher, there is real potential for big trouble for the shorts.  As the stock continues higher in an uptrend, it often becomes tempting to sell short because “it is up too much” or “the P/E is too high”; however, avoiding that temptation and going long is usually the right thing to do until the stock rolls over and shows weakness.  Essentially, the potential short squeeze candidate is a security in an uptrend that has attracted a large short interest and has strong fundamentals.

The final, and probably least important, factor to cover in deciding how strong a candidate may be for a short squeeze is the fundamentals of the company.  Although poor fundamentals would not preclude a stock from being a potential short squeeze target, a company with strong fundamentals would add to the source of demand that would move prices higher.  When looking at fundamentals on a momentum play, it is important not to look too deep.  Look at the company’s news headlines for sales and earnings information, new product developments and analyst ratings changes.  When reviewing fundamentals, traders should be more interested in why others would buy or sell.  It is important not to make a decision about the company, but only what others may think about the stock.  There are many people who buy and sell stocks based on what the prospects for the company are and we cannot ignore them in making our decisions because of their large impact they can have on price.

equities-content-image-6-5-1

 

equities-content-image-6-5-2

equities-content-image-6-5-3

equities-content-image-6-5-4

Questions