If you have been following the financial markets at all this year, you have probably heard more than you can handle about short squeezes. Seeing people post life changing gains from being invested in stocks like AMC or GameStop may be enticing, but trust us when we say a lot can go wrong in a short squeeze if you don’t know what you are doing. For beginner or casual investors, you’re probably actually better off sitting on the sidelines as you need to have a fairly strong appetite for risk to get involved. For those who don’t mind taking on a bit of risk, let’s take a look at how to survive a Wall Street short squeeze.
What is a Short Squeeze?
Before we dive into the detailed scenarios of investing in a short squeeze, let’s tackle the question that has been on everyone’s mind: what is a short squeeze?
A short squeeze happens when there is an abnormal amount of short sellers with positions in that stock. The squeeze occurs when large amounts of shares are purchased which rapidly drives the price of the stock higher due to a shortage of supply and spike in demand. The short sellers now have to cover their short positions by buying up existing shares, causing the price to climb even higher. The upward buying pressure from both sides leads to an abnormally fast rise in price, just as we saw in GameStop in January, and recently with AMC as well.
Remember that a short squeeze isn’t necessarily an indication of a fundamentally good company. In fact, there is often a reason why institutional investors hold short positions in these firms: they think that the stock price is overvalued for the underlying company. Most of the time this is true, as we see with some of the meme stocks that are being squeezed these days. But remember, Tesla also experienced a short squeeze where 18% of its shares were shorted, and the stock proceeded to run 400% over the next year.
So if the company does not support the price of the stock, it means that the short squeeze is artificially propping up the price. This also means that the downside of the short squeeze can come twice as fast as the rise up. Investing into a short squeeze is playing with fire, just ask all of the people who are still holding the bag from the last Reddit short squeeze event.
How to Invest in a Short Squeeze?
The best strategy to have when investing into a short squeeze is to be quick to sell if things start going bad. This is not something you want to try and wait out, once the downside comes, it comes fast. If you are lucky enough to make a profit, take it. Another suggestion is to liquidate your position in the stock that’s being squeezed at the end of every trading session. There is nothing worse than seeing a volatile stock drop 30% in after hours trading and not being able to do anything about it.
What Indicators Should You Look For?
- Is there a large short position? Most financial sites can provide you with the percentage of outstanding shares that are shorted, but it also helps to use a stock scanning service to get the full picture. Check to see just how many shares are shorted. Typically the higher number, the harder the stock will squeeze. Anything over about 10% being shorted is what you want to see, remember Tesla had a short percentage of 18% and GameStop had a short percentage of 140% back in January of 2021.
- Is the short position growing? Another indicator that institutions are bearish on the stock is if the short percentage keeps rising. This will require you to track the stock for a period of time, and you can definitely set up alerts in a screener for this. If that short percentage continues to rise, you know you’re in the right place for a potential short squeeze.
- Daily Trading Volume: This is a good one to watch for, because usually as this rises, more interest is coming in on both sides of the stock. In the recent AMC squeeze, the daily trading volume hit over 500 million shares per day at the height of it. If you can see that the daily trading volume is coming in over the average daily trading volume, then you know something is up.
- Technical Analysis: This may be for more experienced investors, but you can certainly use technical analysis to identify bullish trends in the chart of the stock. The RSI or Relative Strength Index shows how strongly a stock is performing relative to the broader markets. When the RSI falls below about 20, the stock is considered oversold and potentially ready for a squeeze. Keep an eye on other bullish indicators like a rising moving average price, or a long period of consolidation. When a short squeeze happens, it can skyrocket within days, hours, or even minutes, so always be ready!
How Do I Protect Myself from Downside?
Entering a stop loss as you enter a volatile position in a stock is key to not losing your entire investment if the situation takes a turn for the worst. What is a stop loss?
A stop loss is an order you place as you are purchasing stocks or options, where you can enter a price that your brokerage will automatically sell your shares at. This is generally about 10-20% lower than your entry point, to allow for some short-term volatility. If the stock crashes, you will automatically sell your shares at your stop loss price, and the downside is limited. One disadvantage to this is if you are wanting to take a long position in the stock and some short-term volatility triggers the stop loss. By the time you re-buy those shares, they could have surged past your initial entry point.
Final Verdict on Short Squeezes
There may be no riskier type of investment than trying to time a short squeeze, but for those who insist on doing it, make sure you take the following steps:
- Take profit when you get it
- Sell at the end of each day
- Enter a stop loss to minimize downside
If you can follow these simple steps, you should be able to limit how much you lose, while gaining exposure to near unlimited upside. Greed is often the worst enemy of an investor, so if you are fortunate enough to turn a profit, make sure you realize those gains by getting out as soon as you can!