A short squeeze is a trading term that happens when a stock that is heavily shorted all of a sudden gets positive news or some kind of catalyst which brings a lot of new buyers into the stock.

When this happens, the stock is being bought up and the shorts are now forced to cover their positions (getting squeezed out), which then results in more buying that can cause a stock to go up very quickly and by a lot.

You can find short information on stocks through most financial sites like Yahoo and Google Finance. They list the short interest and the percentage short of the float along with the short interest ratio.

The short interest ratio (SIR) measures the amount of shares short divided by the average daily trading volume.

So if the SIR is 3, then that means it would take 3 days at the average volume levels for shorts to buy back their shares. However, when a squeeze is underway the volume is usually increased by a lot so shorts could cover more quickly.

The important part to remember is that when a short squeeze is underway, you don’t want to be caught on the wrong side of it.

Why They Happen

Short squeezes often happen at the end of deep slumps, like the one we saw in March as coronavirus fears took hold. At such points most traders have already sold shares.

“In general, short squeezes are precipitated by large mark-to-market losses due to upward price movements of the shorted stock and/or high stock borrow financing rates which make it unprofitable to stay in trades for long periods of time,” says analyst Ihor Dusaniwsky of data firm S3 Partners.

Short Squeeze Examples

What also happens is new buyers are alerted when prices start to move which even further magnifies the buying and could cause a stock to go parabolic.

Dryships

A good example of this was Dryships ($DRYS) that ran up over 2,000% following the news that Trump won the election.

This stock was heavily shorted but with the surprise win, shares were back in favor and buyers drove the stock up causing shorts to cover and the stock to shoot up. Shares were trading below $5 per share but over the span of just 4 day, shares breached $100 per share!

Volkswagen

Here is an example of a short squeeze: In midst of the 2008 financial crisis something unexpected happened. German automaker Volkswagen was almost heading for bankruptcy but ended up becoming the world’s most valuable company for one, brief day.

 

Back then, investors and hedge including Elliott Management Corp and D.E. Shaw had shorted Volkswagen shares. However, these investors were not aware that Porsche SE had been quietly buying almost all freely traded ordinary Volkswagen shares in an attempt to take over the company.

In March 2008, Porsche SE denied claims that it planned to take over Volkswagen. Several months later the company disclosed it owned 42.6% of Volkswagen freely traded shares as well as controlling another 31.5% through financial instruments.

Then came the squeeze. When Porsche disclosed it had amassed control of roughly 75% of the shares in Volkswagen, short covering reached proper squeeze level, pushing Volkswagen shares from a low just above €200 on Oct. 19 to an absolute peak of €1,005 on Oct. 23.

This short squeeze briefly made the Wolfsburg-based automaker to become the most valuable company in the world, worth more by market capitalization than Exxon Mobil.

Investors and hedge funds that had shorted the stock were caught off guard and suffered massive losses, and some ended up taking legal action against Porsche SE.

The sudden news, combined with a large number of short positions and a very small float, caused the stock to skyrocket within a short period as investors desperately tried to cover their positions.

“It was one of the most painful days in my career,” Arndt Ellinghorst, then at Credit Suisse, but now a Senior Managing Director at Evercore ISI says, according to the Financial Times. “The pain among investors was unparalleled versus any other market scenario I have encountered.”

Tesla

Another good example of a short-squeeze is Tesla (NASDAQ: TSLA), which has squeezed traders by a year-long bull run that has lifted the stock from $224 last year to above $1,800 as demand for its electric vehicles continues to improve.

 

Tesla has been a target of short-sellers, but the stock has recorded huge gains, prompting the company to issue a 5-for-1 stock split. For months, short-sellers have lost billions at the hands of the Elon Musk-led company.

Tips for Trading a Short Squeeze

As you can see from the examples above, short squeezes are one of the most powerful short-term market catalysts and can generate huge surges in share price. Short squeezes can happen very quickly and can move the stock more dramatically than a normal rally, causing huge losses if you are not paying attention.

What happens is new buyers are alerted when prices start to move which even further magnifies the buying and could cause a stock to go parabolic.

A good way to avoid being caught in a short squeeze is to always place hard stops on your short positions, especially if you are holding them over night.

It is also important to note than not all rushes to buy back shares that have been shorted are sparked by positive news.

Sometimes a rush happens because the prime broker (the part of a bank that is tasked with stock lending) has demanded the return of the borrowed shares.

You need to familiarize yourself with the short interest ratio (SIR), which measures the number of shares short divided by the average daily trading volume of the stock that interests you.

Using a Short Squeeze to Your Advantage

A squeeze can be of great benefit to those traders who hold so called long-positions. For instance, let’s say you are looking at a flawed and poor performing company that underperforms, lacks funding, has inadequate management, and is heavily-shorted.

Now imagine the company publishes a positive press release and its share-price rises significantly to more than $120 apiece within just a few days. In this position, you are highly likely to profit from short sellers who are betting against the stock because the company.

When the price of the stock soars, many short sellers will start to exit their position and buy shares to cover. It is at this particular time that you could profit from the actions of these traders.

Bottom Line

Traders can make huge profits by taking advantage of the short squeezes.

If you are looking to benefit from squeezes, you need to know how to trade them correctly.

No one knows when a short squeeze is going to happen but by keeping track of heavily shorted stocks you can be alerted when one is starting to take off.

Then you can trade it like a momentum stock but make sure to start small because the stock will be extremely volatile.