What is a short squeeze and how can it be predicted?

Find out the definition of a short squeeze, and how traders can go about spotting and navigating them.

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What is a short squeeze?

A short squeeze in trading arises when traders who have shorted a security are forced to buy at a loss when the market subsequently rises instead of falls. This often has the effect of creating more demand, discouraging bears further, promoting irrational sentiment and pushing the market higher still.

Setups to short squeeze markets

When on the lookout for the next short squeeze, there are a number of factors for traders to consider. First is to look for bearish activity in the form of heavily-shorted securities. Where negative sentiment is the predominant mood, a short squeeze can commence to start a reversal and send the price higher. There are a few ways to find setups for potential short squeeze instances:

Firstly, there are fundamental drivers. For example, economic or macro information can set up a short squeeze situation after a security becomes oversold. In the below example, Tesla trended bearish on production issues and a crash involving one of its models, leading to a short squeeze when a reversal influenced by an Elon Musk tweet prompted many to exit their short positions.

Secondly, there are technical indicators. Signals such as oversold levels on the RSI, or the MACD line crossing above its signal line, can indicate a potential reversal of a downtrend which may lead to a short squeeze. Also, daily volume can reveal if the number of shares, for example, being shorted is increasing or decreasing.

Understanding shorting before the squeeze

Before trying to predict a short squeeze market, participants need to understand the process of short selling. When a security is shorted, traders effectively borrow shares from their broker in order to sell, with the intention of buying it back at a later date at a lower price. The difference between the initial sell price and a lower buy price represents the profit. The difference between the initial sell price and a higher buy price represents a loss.

In a short squeeze situation, those who are short will see a market turn to the upside, meaning their situation is no longer profitable. In order to limit their loss, they can close their short position if they think a bull market will endure. If enough market participants act the same way, the security will surge higher.

How to predict a short squeeze

When it comes to predicting a short squeeze, using a stock example, traders can use the short interest percentage and the short interest ratio. The short interest percentage shows the number of short sellers competing against each other to buy the stock back in the event of a price rise. The higher the short interest percentage, the more traders there are looking to buy the stock instead of shorting it.  

Traders can also use the short interest ratio, which divides the quantity of shares short by the average daily trading volume of the stock. The higher the ratio, the more likely those with short positions will help drive up the price.

Looking at moving averages and other technical indicators can also show peaks and patterns in a security’s price that may be useful in this scenario.

Short squeeze example: Tesla short squeeze

In this example, a Tesla short squeeze occurred when the US automobile manufacturer saw its stock tumble on negative PR in March 2018, followed by a surge as bears sought to buy back the stock and limit losses as the price continued to the upside.

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