Short Squeeze Trading Strategy — What Is It? (Example)
Last Updated on October 24, 2022
There are times when the prices of stocks move as a result of what other investors are doing rather than based on the company’s underlying business fundamentals. One such event is the short squeeze.
A short squeeze happens when there is a high volume of short positions (betting that the stock would decline), but instead, the stock’s price shoots up, forcing the short sellers to exit their positions by buying back the shares, which in turn causes the price to jump higher. A short squeeze can make the price of a relatively unknown stock skyrocket over a short period. Backtests reveal that short squeezes are rare and it’s very difficult to find any short squeeze strategy.
Want to learn more about short squeezes, keep reading!
What is a short squeeze?
I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”
– Victor Niederhoffer, The Education of A Speculator, page 267-268.
A short squeeze is when a heavily shorted stock’s price goes up instead of down, forcing the short seller to exit their positions by buying back the shares at the new higher price so they can return the borrowed stocks, thereby enduring heavy losses. Thus, short sellers add fuel to the fire and make short squeezes extremely painful for those short. That said, these painful moves are, in general, pretty rare.
Short squeezes can make short sellers lose a lot of money on their trades because unlike price declines, which are capped when the share price reaches $0, price advances theoretically have no limits.
Short squeeze example
Let’s say some investors believe that stock XYZ is overvalued at its current share price of $50, and they borrow other’s shares of the stock and sell (short selling), with the hope that the share price would drop to say $30. However, instead of the share price dropping, it rises to $65 and keeps rising, probably following a better-than-expected earnings report.
Since the short sellers would have to return those borrowed shares to the lenders, they would need to buy back the shares at a higher price. Assuming there are many short sellers who want to buy back shares before they lose even more money as the stock rises, they would have to compete with each other in a sense, because others are also clamoring to get rid of their stock.
It’s kind of a FOMO effect. This scramble to buy the stock further pushes the share price up, and there’s no fundamental limit to how high the stock could climb as brokers initiate margin calls forcing shorts to buy to cover.
Here is a short squeeze example in Gamestop (GME):
In early 2021 the share price went from 5 to 80 dollars! We can assure you those who were short could really feel the pain of this move.
Short selling is difficult
Short selling is difficult because you can only make 100% while the losses theoretically can be unlimited. If you buy stocks it’s the opposite. Additionally, the price of most assets over time goes up so you are facing a headwind when shorting.
We have covered short selling in separate articles:
- Pros And Cons Of Short Selling – Why Is It Difficult?
- Is High Short Interest Good Or Bad?
- Short Selling Trading Strategies – Is It Possible To Make Money With Shorting Systems?
But having short strategies in your portfolio of trading strategies is a very lucrative addition to your portfolio! Even though they might not be so good on their own, they might add tremendous positive diversification.
If you’re having problems developing short strategies, you might get help by looking at our short strategy bundle that is avail from our shop:
Top biggest short squeeze in history
These are the most notable short squeezes in history:
- Volkswagen (OTC: VWAGY): In 2008, Volkswagen saw its stock price jump by more than 300% in a matter of days, briefly making the company the most valuable publicly traded company at the time. A number of factors contributed to the squeeze. One of them was that the holding company Porsche SE owned a big chunk of the shares, and the German government also owned a large stake. This meant that relatively few shares were actually traded in the public market. Moreover, there were speculations that Porsche would buy the rest of Volkswagen.
- GameStop (NYSE: GME): In January 2021, GameStop was a relatively unknown stock that was heavily shorted by hedge funds. But its stock price rose from $17 to a peak of $483 within a month following a short squeeze event coordinated by retail investors on a Reddit.com forum called WallStreetBets. At some point, GME reached $20 billion in market cap and had more daily trading volume than AAPL. Large hedge funds such as Melvin Capital suffered 50% losses during a short period and required emergency capital injections that resulted in costly dilution.
Are short squeezes illegal?
In the U.S. stock market, a short squeeze may be illegal, depending on whether there was a manipulation of the stock price or the availability of the stock in bringing about the short squeeze.
In the words of the US Securities and Exchange Commission (SEC):
Although some short squeezes may occur naturally in the market, a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal.
Naked short sales are illegal. “Naked” means that you have not borrowed the shares, thus creating artificial increase in the amount of outstanding shares. But most brokers don’t let you short sell any stock without having located and borrowed the shares.
In the derivative markets it’s different: there is no requirement for borrowing any shares or contracts before you sell short. Derivatives are a contract between you and the seller and thus face no limits in the amount of contracts that can be issued. This is further explained in our article ETFs vs Futures.
How long does a short squeeze last?
How long a short squeeze lasts is not set in stone. It generally depends on the volume of shorted shares, the short interest ratio, the average daily trading volume in the stock, and the broker’s eagerness to recall the borrowed shares.
However, short squeezes typically don’t last long, often within 2-4 weeks. Most short squeezes last less than a month.
The Volkswagen short squeeze, one of the most popular in history, took about 31 trading days to climax. The GameStop short squeeze lasted less than a month, even though the stock later rallied for several months after gaining popularity from the short squeeze.
Short squeeze trading strategy
It’s practically impossible to backtest a short squeeze trading strategy. What is a short squeeze and what is not? A quantified strategy needs very precise trading rules and settings. We decided it was not worth the time to spend time backtesting a short squeeze strategy.
However, we can shed some light on some general principles about a short squeeze trading strategy. Because a short squeeze requires a certain number of short sellers covering their positions, we would assume most short squeeze stocks have a high short interest (meaning a huge portion of the free float is shorted) or a high short interest ratio. For example, if a stock has 500 million shares outstanding and 50 million is lent out for shorting, it means that the short interest ratio is at 10%.
Is a high short interest ratio indicative of an imminent short squeeze? No, in our backtest we see no indications that this is a viable strategy. We looked for stocks with a high short interest ratio but overall this is poor strategy for longs. The fact is this:
High short interest stocks underperform massively compared to low short interest stocks, thus we believe it’s not worthwhile to look for any short squeeze strategy. We have written more about high short interest in our article about is high short interest good or bad?
Short squeeze trading strategy – ending remarks
Short squeezes are very rare. They get a lot of media attention when they do happen so traders and investors have the impression they happen more frequently than they do.
Furthermore, short squeezes are random and we fail to see any clear pattern. We tried backtesting several short squeeze strategies but we failed to produce any tangible positive results.