When the price of a stock begins to rise rapidly, short sellers want to get out, because they only profit when the stock goes down. They can face theoretically unlimited losses when stocks go up. Their pain, however, may be a gain in size.

Understanding short presses

Before you can understand short squeezes, you need to understand how short selling works.

If a short seller thinks a stock is overvalued and the shares are likely to fall, they can borrow the shares through a margin account. The short seller will then sell the stock and keep the proceeds in the margin account as collateral. Eventually, the seller will have to buy back shares. If the price of the stock has fallen, the short seller makes money due to the difference between the price of the stock sold on margin and the reduced price of the stock paid later. However, if the price increases, the repurchase price could increase beyond the original sale price, and the short seller will have to sell it quickly to avoid even greater losses.

Example of short press

Suppose Company C was borrowed on margin by a trader who then sold 1 short 00 shares at $25. A few days later, Company C’s stock price drops to $5 per share, prompting the trader to buy it back. In this case, they win $2,000 [($25 x 100) – ($5 x 100)]. However, if the price of the stock goes up, the short seller is still responsible for the price of the stock when it is sold. So if the trader buys back the stock at $30 instead of $5 (as in the example above), the loss is $5 per share, or $500.

But what if there are a lot of short sellers out there who want to buy back shares before losing even more money as the stock goes up? In such a case, they have to compete in a sense, as others are also clamoring to get rid of their stock – and there is no fundamental limit to how high the stock could go when brokers initiate margin calls force shorts to buy to cover. Therefore, there is no limit to the price the short seller could pay to repurchase the stock.

This is where the short seller comes in and buys the stock, while the panicked short sellers cause prices to rise again due to short-term demand. A short squeezer must not only learn to predict and identify short squeezes, but also to choose the right time to sell the stock, which is at or near its peak.

Predict short compressions

Predicting a short squeeze involves daily interpretation moving average graphs and calculating the short interest percentage and the short interest ratio.

Short interest percentage

The first predictor to examine is the short interest percentage—the number of shares sold short divided by the number of shares outstanding. For example, if there are 20,000 shares of Company A sold by short sellers and 200,000 shares outstanding, the short interest percentage is 10%. The higher this percentage, the more short sellers will compete with each other to buy back the stock if its price starts to rise. (For more, see: What a short interest tells us.)

Short interest rate

The short interest rate is the short interest divided by the average daily trading volume (ADTV) of the title in question. For example, if you take 200,000 shares short and divide them by an ADTV of 40,000 shares, it would take short sellers five days to redeem their shares.

The higher the ratio, the higher the likelihood that short sellers will help drive the price up. A short interest ratio of five or better is a good indicator that short sellers might panic, and it can be a good time to try to trade a possible short squeeze.

Charts of daily moving averages

Daily moving average charts show where a stock has traded over a given period. Examining a 50-day (or longer) moving average chart will indicate if there are any spikes in a stock’s price. To view charts of moving averages, consult one of the many charting software available. These will allow you to plot this on the chart of your chosen stock.

Headlines can also trigger a short press, so stay informed of what’s happening in your area of ​​action.

The essential

The right timing of a short squeeze can be a very lucrative strategy, but with this high reward potential comes high risk. Timing a peak is no small feat. A trader looking to profit from a possible short squeeze should do a thorough study of short squeeze predictors, including short interest, short interest ratio, daily moving averages, and industry trends.

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