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2011-12-28 07:44:57
When stock prices start to rise rapidly, short sellers want out. This is
because an investor who shorts stocks only profits when the stock goes down.
However, an investor's losses are a short squeezer's gains, because the short
squeezer is able to predict the window of time in which a stock will be on the
rise, buy into the stock and sell then it at its peak. Sound like an appealing
technique? Let's take a look at how it works - and when it fails.
Understanding Short Squeezes
Before you can completely understand short squeezes, you have to understand how
the shorts, which create opportunities for squeezes, work.
If a stock is overvalued, a short seller will borrow the stock through a margin
account based on a hunch that the stock's price will go down. Then the short
seller will sell the stock and hold onto the proceeds in the margin account as
collateral. Eventually, the seller has to buy the stock again in what's called
a buyback. If the stock's price has dropped, the short seller makes money
because he or she can cash in on the difference between the price of the stock
sold on margin and the reduced stock price paid later. However, if the price
goes up, the buyback price could rise beyond the original sale price, and the
short seller will have to sell it quickly to avoid higher losses. (For more
insight, see the Short Selling Tutorial.)
Example - The Anatomy of a Short Sale
Suppose that Company C was borrowed on margin and that "Short Seller Bob" then
sold 100 shares at $25. Several days later, Company C's stock price drops to $5
per share and Bob buys it back. In this case, Bob earns $2,000 (($25 x 100) -
($5 x 100)).
However, if the stock price increases, Bob is still be liable for the price of
the stock when he sells it. So, if Bob buys back the stock at $30 instead of $5
as in the example above, he loses $5 per share. That $5 times 100 equals $500
that Bob has to pay up.
But what if Bob isn't the only short seller who wants to buy back shares before
they lose even more money as the stock rises? He'll have to wait his turn as he
tries to sell, because others are also clamoring to get rid of their stock, and
there's no limit to how high the stock could climb. Therefore, there isn't a
limit to the price the short seller could pay to buy back the stock.
This is where the short squeezer comes in and buys the stock - while the
panic-stricken short sellers are causing a further rise in price due to
short-term demand. In this case, the savvy short squeezer who buys the stock
while it's going up must still swoop in at the right time and sell it at its
peak.
Predicting Short Squeezes
Predicting a short squeeze involves interpreting daily moving average charts
and calculating the short interest percentage and the short interest ratio. (To
learn more about this subject, see our Moving Averages tutorial.)
Short Interest Percentage
The first predictor to look at is the short interest percentage: the number of
shorted shares (short interest) divided by the number of shares outstanding.
For instance, if there are 20,000 shares of Company A sold by short sellers and
there are 200,000 shares of stock outstanding, the short interest percentage is
10%. The higher this percentage is, the more short sellers there will be
competing against each other to buy the stock back if its price starts to rise.
(For more information on short interest, please read Short Interest: What It
Tells Us.)
Short Interest Ratio
The short interest ratio is the short interest divided by average daily trading
volume of the stock in question. For instance, if you take 200,000 shares of
short stock and divide it by an average daily trading volume of 40,000 shares,
it would take five days for the short sellers to buy back their shares.
The higher the ratio, the higher the likelihood short sellers will help drive
the price up. A short interest ratio of five or better is a good indicator that
short sellers might panic, and it's a good time to buy a short squeeze.
Daily Moving Average Charts
Daily moving average charts show where the stock has traded for a set period of
time. Looking at a 50-day (or longer) moving average chart will show whether
there are peaks in a stock's price. To view moving average charts, check out
one of the many charting software programs available. These will allow you to
plot this on your chosen stock's chart.
News about industries that indicate trends are also good indicators of a
potential short squeeze, so stay informed about what is happening in your
stock's field. (To keep reading on this, see Trading On News Releases and Can
Good News Be A Signal To Sell?)
Risks Involved
If the stock has peaked, it could fall. The success of your short squeeze will
depend on your ability to sell a stock at its peak.
Conclusion
Employing a short squeeze strategy is not without risk, but the risk is reduced
by careful study of short squeeze predictors including short interest, the
short interest ratio, daily moving averages, and industry trends.
by Reyna Gobel, MBA