Short Squeeze: What It Is and How To Make The Most Of It

What is a short squeeze? How to identify a squeeze and how to prepare correctly for this type of market behavior? This article explains the phases of a short squeeze and explains a powerful trading strategy.

What Is a Short Squeeze?

A short squeeze happens when short sellers get into panic mode. Think about it like that; short sellers placed their bets on falling prices per share on a specific stock. They may come up with their opinion due to technical analysis, pattern recognition, high-frequency trading tactics, or order book valuation analysis.

Everything confirmed the short sellers bias, and they are all in. If stock prices go to the downside, then they win. But what happens if the market pushes just a bit lower and then the price per share rapidly rises? If that happens, a short squeeze is on its way. Previous highs get taken out after short sellers heavily shorted shares.

Phases Of a Short Squeeze

A short squeeze happens when the price per share moves strongly against the predicted price per share. The starting point for all short squeezes is when many sellers identified a potential short and took a short position by selling shares they do not have. Most brokers allow shorting shares these days. The list of easy to borrow shortable shares includes a few thousand stocks when talking about NYSE and Nasdaq listed stocks.

1: The First Bounce

There are huge short positions on a particular stock. Investors shorted the stock since it doubled its prices within a few days, we broke below the previous day low, we opened with a gap down, or just because someone had a gut feeling that the stock prices will fall. So many people are convinced that the stock will head lower that most people are short. They all borrowed shares to open a short position.

2: Day Trader Trap

If a day trader borrows shares to short a market, he intends to see the stock price going lower. He may notice that the average daily trading volume was higher than usual, and short selling was just a great idea when the market opened. The share price fell below its pre-market lows, and he decided to short stock at a price per share of $100.

The day trader is short, the pre-market low got broken, and the first lower high is formed. The day trader gets confident that it is a good idea to increase the number of shares short since he also noticed an excellent market catalyst supporting his opinion. But then, out of nowhere, the market bounces after the lower high.

Instead of running to the next lower low, the stock market and his shares turn around sharply, and the high of the newest lower high gets broken. The day traders now have to cover their positions. The first stage of the short squeeze just began. 50% of all day traders who sold short the share cut their losses, but the other 50% still believe in the selloff. Instead of trading alongside the rules, 50% of day traders are still short.

What they did not realize yet is that the short squeeze occurs right now. After the previous high was taken out, a new slight downside move starts. Those who are still short are so happy and add more shares to their shorted stock position. This is a typical beginners trap. They did not realize yet that the market formed a higher high, and now it is forming a higher low, which leads to even higher prices, and the short squeeze hits them even harder.

3: Swing Trader Trap

Swing traders often open their market position based on the data and short interest ratio of a particular stock. They analyze the market cap. They consider the short-interest ratio and focus on stocks with a high number of short sellers and with a stock price being below the previous market close. The swing trader is a bit more relaxed, and instead of watching intraday trading patterns, he just watches stock performance since open.

He shorted at market open near the pre-market low since the pre-market was weak. He wants to make money trading stocks short. As a short seller, he wants to see the stock prices going lower. But the market squeezes. The possibility of winning was mathematical 50%, and the swing trader was convinced that the probabilities were more in his favor. Now, the day traders already needed to cover their positions, by latest with the higher high.

At this point, the market also trades through the opening price. This puts the swing trader in an unfavorable position. Is account had shown excellent gains once the pre-market low broke after he shorted the stock at the open. But the short covering of those day traders led to high relative volume and pushed the price back through the opening price. Now, the swing trader has to buy back the shares he shorted. He wants to avoid margin calls, and he also does not want to hold big positions too long. As a result, the demand for buying shares gets higher and higher, and the stock squeezes from its lows.

4: Position Trader Trap

A position trader opens his positions to hold it overnight. He has to pay higher financing rates to hold short positions overnight. A position trader uses a lower number of shares, but there are often more sellers on a daily basis, so the overall short exposure is relatively high. The position trader analyzed the price movements, overall market conditions, the short float per share, and he took a closer look at the statistics for the days to cover needed based on the overall short float. A short seller wants to avoid buying back his shares for a higher price than he sold the shares short. He wants to make sure that the average daily trading volume helps him with his prediction.

But he has overseen the short interest in the stock. When the short selling began, the stock was already heavily shorted. He now realizes it, but the position trader thinks he has a low number of shares short, and the short sellers will make a profit here, so he will. The shorted stock opened lower than on the day when he sold shares short. Unfortunately, his brokes defines the stock as hard to borrow, and he also has to pay high interest rates overnight. Anyway, he is convinced that everything is on track.

The stock opens lower than on the previous day, which brings the stock to even more short sellers to attention. The swing traders opened their short positions when the market opened lower, and once the pre-market low broke, the day traders shorted stocks with a high number of shares.

The position trader was the first trader who got short, but he is the last who faces the short squeezes. The position trader saw the markets fall and notice a first quick bounce. He uses his stock market news platform to analyze the company catalyst, but he does not identify anything that supports heavy buying. The position trader does not recognize that day traders and swing traders first get hit by short squeezes. Not a specific company news catalyst causes the movement. It is the mother of all short squeezes that’s happening right now.

One position trader after the other closes his short position with a market order. All short sellers got hit pretty hard on that day. They heavily shorted the stock, and all short sellers got burned. Some sold short stocks. Some used options trade to bet on a falling price per share. Suddenly and without any specific news, the prices turned around, buyers came in, and short sellers realized losses.

Short Squeeze Profits

Short squeezes happen all day. And even if you analyze everything and make only well-informed decisions, those type of price action just happens. There are some theories out there that you can avoid short squeezes by avoiding shorting stock with high short interest. The reason behind this theory is that if it takes a couple of days to close all short positions, then the risk of a short squeeze is higher.

You can use free tools like Finviz to check the short float and short interest. But the point is, it is more interesting to use a short squeeze to generate additional income. Use the trap in your favor being on the long side instead of the short side. Here is what you can look out on your charts:

Outside Candle On The Daily Time Frame

You can use a stock screener like Trade Ideas to identify those stocks that already broke the previous day low and then sharply turned around and broke the previous days high intraday. This is often a fantastic opportunity to scalp a few dollars by making money while others get squeezed.

Intraday Power of The Daily Outside Candle

This strategy is powerful since so many traders entered the market short when the previous day low broke. The added positions, some of them are on hope mode, and they all have one thing in common. All those short sellers see the break of the previous day high as a subsequent move after breaking the previous day low as the ultimate stop loss.

They are all so convinced that that will never happen, and they put buy stop market orders in their system. And then it comes like it had to come. The ultimate stop gets hit. They all get stopped out. This high relative volume can boost your account a bit by buying shares closely around this level and selling right into the price rally when the previous day high gets broken. Shorts get stopped out and have to buy back shares. They make losses, and you use the short squeeze in your favor.

Outside Candle on The Intraday Time Frame

Things that work on a daily time frame also work on an intraday time frame.

15 Minute Chart

Use your trading platform and open charts of 10 different stock symbols. You will notice that short squeezes happen all the time. Digging deeper into this topic, you will notice that the squeeze is the hardest when most trader types are shorted. An outside candle on a 15-minute chart alone often ends in whipsaw.

But suppose the previous day low was taken out. When we were below the pre-market low, and a higher low and higher high got formed, the price per share crossed the opening price. Then a 15 minute outside candle occurs. You will often see much more decisive price action due to the short squeeze initialized buyback activity of all short sellers.

5 Minute Chart

The same holds true on any intraday time frame. The shorter the time frame, the more false signals you will get. If you want to make money trading short squeezes, you need to be patient and wait for high relative volume once the market turns around. You need to watch the charts closely and the price action in real time. You will notice when the prices flip up and down, and the volume in your volume bar moves strongly to the upside. This is the first indication that people are covering their positions.

Short Squeeze Summary

A short squeeze is a powerful move per share to the upside. Short sellers have to cover their short position by buying back the shares shorted. Figures like short interest, relative volume, unusual options trades, market catalysts, and short float should be analyzed before opening a short position. All short positions have to be protected with stops because short squeezes unfold a strong, sharp move to the upside often.

A short squeeze can also be used to make money by analyzing a market and identifying shares where a short squeeze happens right now. Hotkey trading and automation are helping to make money intraday by entering and exiting positions fast and accurately.

A stock market scanner like Trade Ideas can be used to identify short squeeze patterns. Intraday high relative ranges and high relative volume are a good starting point, also stock who high the previous day low and then the previous day high are interesting stocks to analyze further. Like any trading strategy, even a short squeeze trading strategy requires an exact trading plan and trading strategy definition.

Just clicking around and hoping for the best is gambling. It all starts with analysis, and then precise parameters have to be defined. Finally, the trading plan has to be traded according to the rules defined.

Updated: December 04, 2020

About the author: Alexander is the founder of daytradingz.com and has 20 years of experience in the financial markets. He aims to make trading and investing easy to understand for everybody, and has been quoted on Benzinga, Business Insider and GOBankingRates.