Short squeeze can spell disaster for sellers in the stock market if they don’t act quickly. In today’s article, we’ll look at everything you need to know about short squeeze or short compression, including the causes of it, ways to identify and how to bargain.
What is market compression?
Market compression can refer to either shorts or long squeeze. Short squeeze to sellers who are effectively “forced out” of the market in light of fast-growing prices. They will try to get out of their short positions as quickly as possible to reduce their losses.
Long squeeze is when buyers are “pushed out” of the market due to suddenly falling prices. Again, they will try to quickly close their positions to prevent heavy losses.
What is short squeeze?
Short squeeze is when prices rise too fast, which is at odds with the expectations of analysts and market participants. Short squeeze can particularly hit investors who use leveraged stocks because they can spend more money to buy back and return borrowed shares.
This situation can also harm traders who trade stocks with derivative financial instruments such as CFD. This is due to the fact that derivatives are traded with leverage that can increase both your profits and losses. This is especially true during shorts, when markets behave in unexpected ways and volatility increases greatly.
Short compression is caused by a rapid and unexpected jump in the asset price. Sellers will seek to give up their short positions as prices rise.
This is causing an increase in demand for stocks, which reduces supply. This shift in supply and demand dynamics leads to further price increases, which exacerbates the effect of short compression.
If investors use a short-covering strategy, they need to buy back borrowed shares to open a short position before the expiration date. The expiration date is the date when the borrower agrees to return the shares to the lender.
Often a short compression is caused by positive news and usually occurs on Friday, when traders do not want to go out for the weekend from a short position when the markets are closed. Positive news may support the share price on Monday.
Overall, over the past few years, short sellers have had a rather difficult time due to the overall growth of the stock market.
How to spot short squeeze in the market?
To identify short squeeze, many traders will use indicators to find oversold stocks. If stocks or other assets are resold, you can expect their price to increase. Popular indicators that are used to identify oversold areas include RSI Relative Strength Index And Momentum indicator.
In the graph below, RSI is the top indicator and momentum is the lower one. The oversold areas are rectangular.
You can link these figures to the total number of shares that have been sold. This can help you confirm the readings of the indicators. A lower percentage of short positions means that fewer people are now trading company shares. This means that they can expect the share price to rise.
To see the interest, divide the number of shares sold by the total number of shares in circulation, and then multiply the result by 100.
Short squeeze usually take markets by surprise, and oversold indicators and high or low interest rates do not guarantee that short cuts will happen. Often, higher-than-expected company earnings, technological breakthroughs or new products that shift the sector lead to unexpected price increases.
An example of short squeeze
A notable short squeeze occurred in October 2008, when Volkswagen’s share price (VOWG) doubled from 210 to more than 1,000 euros in two days. This took the markets by surprise, and in a short period of time Volkswagen became the most valuable company in the world.
Porsche announced that it had gained control of 74% of Volkswagen’s voting shares, leading to a sharp rise in its share price as short sellers were forced to pay up to 1,005 euros per share to close their positions.
A more recent example of a short squeeze could be Tesla’s (TSLA) share price in the first months of 2020. Earlier, Tesla shares have been consistently lower in price on the Nasdaq exchange, but a slew of positive news – including fourth-quarter results that beat expectations – caused the price to rise to $900 per share.
Sellers were trapped, and, as in the case of Volkswagen, followed the struggle for the purchase to cover short positions and close losses. This pushed prices even higher, which meant that losses for short sellers increased exponentially.
Below you can see the price of Tesla shares from January 23, 2020 to May 18, 2020. The short compression is circled and marked when the share price changes its trajectory downwards, and the rising share price is shown by the arrow up.
There are some certain rules to find a stock that can experience a short compression.
A short percentage allows you to identify short clicks. It represents the total percentage of shares of any given company that is traded on the market. A short percentage of over 20 is considered by many traders as high.
The time-to-coverage ratio is calculated by determining the total number of short positions on a particular stock and dividing it by the average daily volume of this stock. This shows just how bullish or bearish traders are on the chosen stock. Ideally you want stocks that have a double coverage ratio.
How to trade short squeeze?
- Explore the market you want to trade.
- Do your own analysis.
- Take steps to manage risk.
- Open, track and close your position.
To trade with a short click, you need to open a position that will benefit from rising stock prices. This means that you open a position to buy once you have identified a short compression.
If you trade CFD’s using leverage, which means that you will not become the owner of the shares and will be able to open a position with a small deposit – the so-called margin.
If you prefer to invest directly, you can do so with the help of the appropriate broker. You will become the owner of the shares, becoming a shareholder of the company with the right to vote and the right to receive dividends – if the company pays them.
An investment position would be profitable if the share price went up, meaning that it would often perform well in the face of short squeezes and fast-rising prices.
The short compression is due to the huge demand for a particular share and the subsequent lack of supply. This can be very detrimental to a company that has shares with which it happens. And it can also be a very serious obstacle for traders who will have to pay huge sums for the stock that has grown in price. These compressions can be difficult to predict and so they can be devastating for trading deposits.
Short squeeze often result in huge losses for both the companies that own the shares and the traders who invest in them. Traders and investors may no longer be able to buy shares, which means that they will not be able to make any profits themselves, and companies will not make money from people investing in their shares.
One sign that short compression is inevitable, perhaps, is when the company has a so-called “hard swim”. When the percentage of shares that are traded in the market decreases or seems smaller than usual, it may be a sign that a short squeeze may occur. If you invest in any stocks, remember to follow the news and statistics about the company and how they change from day to day.
Short compression can be beneficial for those traders who hold a long position. For example, imagine looking at a poorly performing and unprofitable company that has inadequate management, is inefficient and has no funding.
However, this is a great opportunity for shorts. Now imagine that this company is making an unexpected announcement, and the share price rises significantly to more than 100 dollars per share in just a couple of days. In this position you can potentially profit from short sellers who expect the share price to fall because the company will continue to operate just as badly.
If the share price rises, short sellers will start to leave their position and buy for coverage. It is at this time that you could benefit from the actions of these traders.