Anatomy of a Short Squeeze

1) What is it?

To initiate a short position, the trader must borrow the stock then sell it. The short trader profits if the price falls.  A short squeeze is said to occur when a measurable percentage of the company's stock has been shorted and where the price approaches or surpasses the level at which short positions were entered. As the stock price moves higher, the motivation by short-sellers to buy the stock back to cover the positions increases. The higher the short interest (percentage of shares in the float sold short), the greater the pressure on shorts to cover or buy back the stock to exit their short positions as the price rises. In other words, the higher the number of shares sold short and more rapid the price rise, the greater the potential lift.

Another important point to consider is that history tells us that short sellers aren't really any smarter than the rest of the market.  When short interest is high (greater than 5% of the stock's float) and the stock changes direction, the majority of shorts end up on the wrong side of the trade. This means that they are highly motivated to quickly exit the trade and in the process this buying drives the stock price higher creating a short squeeze.

In the perfect bullish scenario, a short squeeze helps catapult stocks higher than they would normally go with minimal or no short interest. 

Although a short squeezes can be very powerful, they tend to have relatively short duration with the maximum price increases occurring as stock price passes above the level at which the greatest number of short positions were entered - a price threshold also known as the squeezetrigger. 

Buyins.net tracks data, including short positions on more than 15,000 stocks trading on US exchanges and identifies those that are nearing the SqueezeTrigger.

2) Can you share some examples?

Here we see a daily chart of Imergent Inc. (IIG) that first moved above its squeeze trigger level in April 2006. This level then became support and as we see the platform from which the stock ultimately rallied to more than double the squeeze trigger price.

Figure 1 – Daily chart of Imergent Inc. (IIG) showing it surpassing its squeeze trigger price of $12.33 on September 26, 2006 which then became support from which the stock rallied over the next six months. As we also see, the fundamentals were not particularly enticing with earnings growth (GRT) and growth to PE (GPE) in negative territory and a relative value based on projected fundamentals around one.

Next we see a chart of Basin Water Inc. (BWTR) showing the explosive breakout the stock experienced once past its squeezetrigger. 

Figure 2 – After breaching its SqueezeTrigger of $9.90 on July 17, Basin Water Inc. (BWTR) rallied above $11 by the end of the month. Chart by TradeStation.com 

In this next chart, healthcare company Hillenbrand Industries (HB) shows what happens when the squeezetrigger price is further supported by technicals - in this case trendline and price-volume support.

Figure 3 – Hillenbrand Industries (HB) moved above its SqueezeTrigger of $52.90 November 24 and it is also above long-term trendline support and long-term price-volume support of $51. Given that it is a healthcare company which is a defensive play, this stock should continue to do well if the market continues to prove challenging. As we see from its chart, each time that the earnings growth rate (GRT) has dropped below zero has proven to be a good time to buy the stock.

3) What makes a short squeeze so potentially powerful? 

 Until 2005, it was nearly impossible to calculate the average price at which short sales were entered but thanks to regulation enacted in 2005 by the Securities and Exchange Commission called Regulation Short Sale (RegSHO), data on short trades is now available. Buyins.net collects and collates this data for more than 15,000 public companies which has made such indicators as the SqueezeTrigger possible.  

Over the years short selling (borrowing a stock and selling it short) has gained in popularity. But there is one aspect about short selling that new traders can overlook and that is risk. Unlike a long trade when the risk is limited to the amount of money invested and there is no limited profit potential, the tables are turned for a short sellers. First, the trade the potential for unlimited loss and second, the maximum potential gain is 100%. Consider stocks like Microsoft in the 1990s and Google more recently in which long investors made thousands of percent as these stocks skyrockted higher. A short seller who shorted these stocks would have incurred losses many times their original investment had they not exited these trades.

This characteristic exerts a powerful force on short sellers. When a position starts to lose money meaning their bet was wrong, they face the prospect of an unlimited loss and most under these circumstances will cut their losses and cover or buy back the stock to cover. This has the potential to drive the stock price significantly higher especially if a rally is underway in something called a short squeeze. This is why stocks moving above their SqueezeTriggers in rallies can have such explosive moves.

4) What exactly is a SqueezeTrigger?

A SqueezeTrigger is the volume-weighed moving average of the price at which shorts sold the stock. As the stock rallies back towards this price, the greater the pressure on shorts to cover and the faster it rallies, the more powerful this motivating force. This is clearly evident in the gap and subsequent move in the price of TIVO (see below). The $0.75 gap that occurred on0 November 29 was the result of short covering as shorts fought with buyers to get stock in overnight trading. This short squeeze continued for the next six days before TIVO entered a consolidation phase around $8.25. Investors who owned the stock through this period profited handsomely in a classic short squeeze. 

5) What factors raise the probability a SqueezeTrigger trade will be profitable?

There are a number of conditions that when present increase the probability of making a profitable ST trade. This list is not exclusive but designed to provide some ideas. 

1. Locate stocks that are at or approaching their SqueezeTrigger price. There are two STs, the first is the shorter-term monthly number but the more important is the long-term SqueezeTrigger since it represents a more significant price threshold.

2. The higher the short interest, the greater the potential short squeeze so first focus on stocks that have a short interest of 5% or greater.

3. When stocks are rallying buyers are stepping up and buying the stock and this puts growing pressure on shorts to cover. Upward momentum increases the probability of an explosive move as price moves above its SqueezeTrigger. 

4. Look for stocks with strong technicals. These may include trendline support, a bullish chart pattern such as a head & shoulders bottom, cup & handle, rounded bottom or price-volume support. Trade entry should be confirmed by a technical buy signal such as a moving average crossover or an RSI, CCI or other oscillator cross out of oversold territory.

5. Since a rising tide lifts all boats, it's best to enter long positions when the market is rallying or recovering. However, because they tend to be short-term, SqueezeTrigger trades also work in bear market rallies after stocks have been beaten down into oversold territory and experience a strong bounce. The key is not to overstay your welcome. 

6. Always employ money management. A stop loss of 5 - 10% is a good start with a similar trailing stop (depending on stock price). The idea is to protect profits but not set stops so tight that you will be shaken out of the trade by normal volatility.

7. Fundamental strength is also an asset. Stocks that are growing earnings, have a new product, service or managment team or has issued positive earnings report increases the chances that it will continue to rally.

Check back here again as new short squeeze candidates are highlighted and more short squeeze strategy details are added.