Short Squeeze



Short squeeze refers to a condition wherein a heavily shorted stock or commodity suddenly moves higher, obliging more short sellers to close out their short positions and adding to the increasing pressure on the stock. A short squeeze suggests that short sellers are being squeezed out of their short positions, typically at a loss. A short squeeze is usually caused by a positive development that recommends the stock may be boarded on a turnaround. Even though the turnaround in the stock’s fortunes may only seem to be temporary, few short sellers can afford the possibility of incurring losses on their short positions and may wish to close them out even if it means taking a significant loss.

Short Squeeze (Breaking Down)

If the stock  begins to increase quickly, the movement may continue to increase because the short sellers will likely want out.

For instance,  if a stock increased 15% in one day,  individuals with short positions may be forced to settle and cover their position by buying the stock. If sufficient short sellers buy back the stock, the price is pushed  even higher.

Two useful methods in recognizing stocks at risk of a short squeeze are (a) short interest and (b) short-interest ratio.

Short interest -  talks about the total number of shares sold short as a percentage of total shares outstanding.

Short-interest ratio (SIR) is the total number of shares sold short divided by the stock’s  average daily trading volume.

For instance,  consider a theoretical biotech company, Medico, that has a drug candidate in advanced clinical trials as a treatment for skin cancer. There is considerable skepticism among investors about whether or not this drug candidate will really work, but as an outcome, 5 million Medico shares have been sold short of its 25 million shares outstanding. Short interest on Medico is consequently 20%, and with daily trading capacity averaging 1 million shares, the SIR is 5. It means that SIR would take five days for short sellers to buy back all Medico Shares that have been sold short.

Consider that because of the big short interest, Medico has dropped from $15 a few months ago to $5 shortly before the release of the clinical trial results.

When the outcome is announced, they point out that Medico’s drug candidate works better than anticipated as a cure for skin cancer. Medico’s shares will  gap up on the news, probably to $8 or more. As investors buy the stock and short sellers struggle to cover their short positions. A short squeeze in Medico is now on, it can push it much higher due to huge buying pressure.

Contrarian investors look for stocks with heavy short interest exactly because of a short-squeeze risk. This type of investors may accumulate long positions in a heavily shorted stock if they think that its chances of success are significantly higher than what investors who are bearish on it believe. The risk-reward payoff for a heavily shorted stock trading in the decline single digits is fairly favorable for contrarian investors with long positions.

Their danger is limited to the price paid for it, while the profit possible is unlimited. This is absolutely opposite to the risk-reward profile of the short seller, who bears the risk of theoretically unlimited losses if the stock spikes higher on a short squeeze.

Turnaround

The financial improvement of a company that has been performing poorly for an extended time. In order to influence a turnaround, a company must recognize and identify its problems, consider changes in management and develop and implement a problem solving plan. In other cases, the best approach may be to cut losses by settling the company rather than trying to turn it around.

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