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What is a Short Squeeze?

A short squeeze is simply an increase in a stock’s share price because of short covering. When you short-sell a stock, you borrow shares from your broker and then look to buy/cover them at a lower price. I get asked all the time how to trade short squeezes successfully. 

However, if the stock keeps going up, shorts will have to cover their position in order to avoid a big loss. As short sellers scramble to cover their positions, they have to buy their shares back from their broker, causing the stock price to increase rapidly in value due to the increasing demand. Here some tips to successfully trade short squeezes:

Overbought Can Get More Overbought

Heavily shorted names often will have questionable fundamentals. An important fact to remember when short selling in the stock market: The market can stay irrational longer than you can stay solvent. I have seen the worst companies go up 100’s, sometimes 1000’s of percent on many occasions.

Timing your investments is the most important component of being a successful trader/investor. Nothing is ever up “too much”, and has to reverse. TSLA took about 4-5 years until its poor fundamentals became priced into the stock price. Many prominent short sellers blew from that name because they were short on the front side of the move.

Short Term Trade

It’s best to treat a short squeeze trade as a short term trade, such as a day trade or a short swing trade. In order to trade short squeezes successfully, you have to have very good timing. Usually, the company that is running is usually an overvalued company. But it doesn’t mean that the stock has to go down right away. The short sellers in the stock will probably be correct in the long run, but their timing is off. As a result, they get squeezed because they are on the front side of the move. Beyond Meat is a great example of this.

BYND Example

Beyond Meat has been the hottest IPO this year. It's market cap is about $8 billion, and its net income is $40-50 million. It is definitely overvalued. But that doesn’t mean that it won’t stop appreciating in value in the short term. Once a short squeeze starts on a low float stock like this one, no one knows how far it will go. Take a look at the move it had the day after it announced earnings on Friday and gapped up:

trade short squeezes

Almost everyone was expecting this to get destroyed on its first earnings call. But it didn’t. Because it’s a recent IPO, shortsqueeze.com doesn’t have any data on its short interest. But you can gauge the sentiment that is overvalued based off social media and many news publications. There were a lot of shorts stuck in this from its earnings gap up. 

Once it started to base and make higher lows, you knew this had a high probability of breaking out and squeezing. The shorts got trapped in the sell off from the morning, and they were all underwater once it broke over high of day.  

TLRY Comparison

It’s probably going to have a big pullback at some point. But we are still definitely still on the front side of the move. This has a “TLRY” like feel like to it. Check out what happened in that scenario:

trade short squeezes

You can see how it squeezed from $40 a share all the way to a high of $300. Like TLRY, BYND is a recent IPO with a low float. BYND probably won't go up 500%, but it still definitely has some room to run. In general, you want to stay way clear of shorting recent IPO’s, especially once the break over their IPO high. As you can see from TLRY case study, BYND is by no means overextended yet. It really is only Day 1 after an earnings breakout. There is no reason to be short this stock now.

Short Squeeze Trade Example

Here is a video recap of a short squeeze trade I took last summer:

Margin Calls

When the majority of the traders in stock are short, what happens when the stock starts to go up and they go underwater? Panic starts to set in, and everyone starts to worry they will get bought in by their broker. As a result, you get a move as you see in the last 30 minutes of trading in BYND.

The huge squeeze was caused by a broker buying in one of their clients to avoid catastrophic loss. And it looks like it was a sizable position, causing the stock to squeeze from $140 to $149 in just 10 minutes. Short squeezes will often occur at the end of the day, as that is when brokers will often do forced buy-ins on their clients from losing short positions.

Unlike with a long position, short selling can actually result in you losing more money than you put into a position. When you’re long a stock, you cannot lose more than what you put in, because a stock cannot go below zero (assuming you aren’t using leverage).

However, with short-selling, you can lose more than what you put in. How? The stock can go up more than 100% from your short price, and you can actually go in debt to your broker. Since there is theoretically no limit to how much a stock can increase in value,

Summary

Short squeezes can be great opportunities for capitalizing on short term momentum on heavily shorted companies. But they should not be trades you marry. The fundamentals of the stock eventually get priced in, and the floor comes out from beneath it. These can offer great short term trading opportunities for momentum traders like us. 

About Kunal Desai

Kunal Desai is the Founder and Lead Instructor at Bulls on Wall Street. Since 2008, Kunal has helped thousands of traders reach their trading goals through his unique live trading courses. Kunal is a day trader by day and industry leading instructor by night.

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