A phenomenon in financial markets where a sharp rise in the price of an asset forces traders who previously sold short to close out their positions
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Written byCFI Team
What is a Short Squeeze?
Short squeeze is a term used to describe a phenomenon in financial markets where a sharp rise in the price of an asset forces traders who previously sold short to close out their positions. The strong buying pressure “squeezes” the short sellers out of the market.
A short squeeze often feeds on itself, sending the asset’s trading price even higher and forcing more short sellers to cover their positions.
As traders who previously sold short the asset must buy to cover their positions, the closing out of their short trades simply adds more buying pressure to the market, thus further fueling a rise in the asset’s price.
Summary
- A short squeeze is a phenomenon that occurs in financial markets when short sellers of a security are forced out of their positions by a sharp increase in the security’s price.
- Short squeezes are typically triggered either by unexpected good news that drives a security’s price sharply higher or simply by a gradual build-up of buying pressure that begins to outweigh the selling pressure in the market.
- As short sellers begin to exit their positions, it adds more buying pressure in the market, which can cause the price to rise even higher, forcing more short sellers to cover their positions.
How a Short Squeeze Unfolds
A short squeeze typically unfolds after a stock’s been declining in price for some time. The decline in price attracts more and more short sellers looking to profit from the fall in price.At some point, considerable buying pressure begins to enter the market. It is usually the result of one of two things.
It can be an instance of unexpected good news regarding the stock, such as a very favorable earnings report that far exceeds the expectations of market analysts. It can also be that technical traders begin buying the security as they see indications that it is oversold and, therefore, possibly ripe for a reversal to the upside.
When the new buying pressure that’s entered the market builds to the point where it begins to drive the stock’s price sharply higher, short sellers begin to see their profits erode – or even worse, their profitable positions begin turning into losing positions.
Fearing that the stock will continue its upward move, they move to exit their short positions with the necessary buy order. As previous short sellers enter buy orders to close out their positions, it adds fuel to the buying fire, attracting more buyers and pushing the stock’s price even higher.
As the stock’s price continues to rise, more short sellers are gradually squeezed out of their market positions.
How to Spot an Impending Squeeze
Technical traders monitor certain indicators that may reveal that a stock is ripe for a short squeeze to occur if substantial buying pressure begins to enter the market.
One is the short interest – the percentage of a stock’s total number of shares that are currently held by short sellers. When the percentage of the stock’s total shares that are currently sold short is significantly higher than the normal level, the likelihood of short squeeze is considered to be increased.
Another technical indicator that traders monitor is what is known as “days to cover.” It is a metric derived from comparing the total short-selling interest in a stock to its average daily trading volume.
The computation indicates the theoretical number of days, assuming average trading volume, that it will take for those who sold short to cover – exit – all of their positions. The higher the days to cover number is, the more prone the stock will be to a short squeeze.
Technical traders also look at indicators such as the Relative Strength Index (RSI), which are intended to indicate overbought or oversold conditions in a market. A market is considered to be oversold when the RSI reading is below 20.
Technical traders view the situation as indicating that the market may be due for an upside reversal in price movement. If the security’s price begins to rise, they will start buying it. If there is enough buying interest, short sellers may begin to get squeezed out of their positions.
More Resources
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As an enthusiast with a comprehensive understanding of financial markets and trading dynamics, I've closely followed and analyzed various phenomena, including the intriguing concept of a short squeeze. My depth of knowledge is grounded in years of practical experience, academic background, and a keen interest in financial markets.
Now, let's delve into the key concepts presented in the article about short squeezes:
Short Squeeze Overview:
Definition: A short squeeze is a phenomenon in financial markets where a rapid increase in the price of an asset compels traders who had previously sold short to close their positions. This surge in buying pressure forces short sellers out of the market, contributing to a further increase in the asset's trading price.
Market Dynamics:
- The buying pressure intensifies, creating a cycle where short sellers exiting their positions add more buying pressure, propelling the asset's price even higher.
- Short squeezes often occur after a prolonged decline in a stock's price, attracting more short sellers seeking to profit from the downward trend.
Unfolding of a Short Squeeze:
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Market Conditions:
- Short sellers enter the market during a declining phase of a stock.
- Buying pressure begins to build up, triggered by unexpected positive news or indications of oversold conditions.
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Erosion of Profits:
- As buying pressure rises, short sellers see their profits diminishing or turning into losses.
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Exit of Short Positions:
- Fearing further price increases, short sellers exit their positions by placing buy orders.
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Buying Fire:
- The exit of short positions adds fuel to the buying fire, attracting more buyers and pushing the stock's price higher.
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Gradual Squeeze:
- The rising price gradually forces more short sellers to cover their positions, contributing to an extended squeeze.
Indicators for Spotting an Impending Squeeze:
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Short Interest:
- High percentage of a stock's total shares held by short sellers indicates an increased likelihood of a short squeeze.
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Days to Cover:
- Compares total short-selling interest to average daily trading volume, predicting the theoretical number of days for short sellers to cover their positions.
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Relative Strength Index (RSI):
- Indicates overbought or oversold market conditions. An RSI reading below 20 suggests oversold conditions, potentially signaling a reversal and triggering buying interest.
Additional Resources:
The article provides valuable resources for those interested in furthering their understanding of related concepts:
- Long and Short Positions
- Stock Price
- Stock Buyback Methods
- Volume of Trade
For continuous learning in accounting, financial analysis, and modeling, the article recommends exploring CFI's platform, offering free courses, templates, and cheat sheets for professionals in the field.
In conclusion, the article effectively communicates the dynamics of a short squeeze, from its initiation to the indicators that can help traders spot an impending squeeze. The inclusion of additional resources from CFI further enhances the reader's ability to deepen their knowledge in wealth management.
