In general, investors prefer to buy stocks so that they can sell these stocks at a higher price at a later date. This is basically a buy-and-hold strategy.
Now, the concept of short selling is quite different. Here, the profits are made from an anticipated fall in the price of the stock in the future.
How Is Short Selling Done?
An investor who wants to do short selling would first borrow shares of the Company (say, PQR) from a broker. Then, he would sell these shares of PQR at the market price.
This is done with the hope that he would be able to buy back these sold shares at a lower price in the future. This way, the investor hopes to “cover” the position and give back the shares to the broker.
When buying back the shares, the investor makes profits from the difference between the (high) price when the shares were originally sold and the (low) price of the buyback.
So, unlike the typical “buy low-sell high” concept, the investor seeks to “sell high-buy low” in case of short selling.
How Does Short Squeeze Happen?
Assume that a short selling of a stock was done by an investor. Now, if the stock price does not decline as the investor anticipates, a short squeeze happens. Here’s how!
- After short selling, when the price starts increasing instead of decreasing, many short sellers will begin to buy back or “cover” their shares to minimize their losses.
- This buying spree would cause the price of the stock to rise further.
- This would, in turn, force more short sellers to cover. This is because sellers may be required to put up more capital to hold on to the short position, or would be liquidated from the position if they did not cover immediately.
- Now, if the substantial price substantial price rally, it would create panic buying by investors who had taken shorts. This would drive prices higher.
- This rapid increase in the price of a stock that happens when there is a lack of supply and an excess of demand for the stock is called as a “short squeeze.”
Meanwhile, the investors who have remained long on these shares usually gain a massive profit from such ‘Short Squeeze’.
How to Identify Short Squeeze?
Following are some of the ways to identify short squeeze.
- A high short interest: This usually signifies that some sort of squeeze went on, especially if the stock pops very aggressively. The Short interest as a percentage of float ratio and Days to cover ratio are highly useful in this regard.
- A Higher than average volume: Whenever the trading volume is higher than average, it could be caused due to the short squeeze.
How to Profit from Short Squeeze?
Once a potential short squeeze stock is found, there are two ways of trading it and making profits from it
- You can buy the stock for the short-term to take advantage of the potential spike in price.
- After short squeeze, as soon as the buying pressure eases, enter a short position. This should be done for stocks that are in downtrends.
Remember to keep the stop-loss orders relatively tight in order to control risk.