How Can You Profit From A Short Squeeze?

The definition of a short squeeze is a scenario where a stock, index, commodity or currency surges higher forcing short sellers to exit their positions. How can you identify a short squeeze and profit from it?
Short Squeeze

Markets are fickle. You never know when sentiment will take control and move in an unexpected direction. There are times during a trend or even a range bound situation that despite the fundamental backdrop prices of specific security will not move lower. When everyone is bearish and negative sentiment is exaggerated a short-squeeze can commence sending prices surging. There are several ways to measure if specific players are short. By using a combination of regulated reporting tools and technical analysis you can quickly determine if the market is offsides.

What is a Short-Squeeze?

The definition of a short squeeze is a scenario where a stock, index, commodity or currency surges higher forcing short sellers to exit their positions. The acceleration in the upward pressure drives irrational sentiment pushing prices higher. The term denotes a situation where short sellers are being squeezed out of their short positions. When you are short an asset, you are generally speculating that the price of the asset will decline. When you are short regulated security such as a US commodity or equity your short position is reported to the regulators of that market. Short positions in OTC currencies or CFDs are generally not reported. When you short a stock, you need to borrow the stock from someone else who owns it. The goal is to buy the stock back at a lower price and repay the loan that you used to borrow the stock.

What Starts a Short Squeeze?

The impetus for the squeeze can come from fundamental factors, where a rebound is justified, or negative sentiment becomes unsustainable creating irrational price momentum. A fundamental impetus could be economic or macro information which you can follow on Olymp Trade. Most of the time, those who have short positions are closing their position at a loss during a short-squeeze.

How Can You Determine if the Market is Short?

Before a short-squeeze commences, and prices begin to rise, you can observe how the market is positioned using specific tools. For example, one of the best tools is the Commitment of Trader’s report released by the US Commodity Futures Trading Commission. This report is released every Friday unless there is a holiday during the week. The report reflects specific holdings per investor. Investors are categorized by size and occupation. For example, swap dealers managed money and retail investors are reported separately.  Swap dealers are liquidity providers to investment managers and commercial entities. Managed money funds and retail investors are self-explanatory.

For stocks, short interest reporting is readily available. All short interest positions by FINRA member firms are reportable twice a month. The SEC also requires short interest reporting. Member firms are considered members of an exchange such as the NASDAQ and the New York Stock Exchange. The exchanges report short interest generally twice a month. The first time during the middle of the month and the second time at the end of the month. The exchange has a mechanism to handle stock splits that occur inter-month.

How Can You Trade a Short-Squeeze?

Your goal is to purchase an asset when you believe that market participants are offsides and negative sentiment is overdone. As mentioned, you can use tools such as the Commitment of Trader’s report of exchange short interest to determine if there is a large short interest in a stock or commodity.

CFTC Net Short Positions

The table above is a picture of the disaggregated Commitment of Trader’s report for a combination of futures and options for the date ending November 20, 2018. Each futures contract is reported separately. The soybeans contract that is traded on the Chicago Board of Trade shows that managed money is short 132K contracts compared to long 72K contracts. The number of shorts is nearly double the number of hedge funds that are long. This is a sign that speculators are somewhat convinced that prices will continue to trend lower.

There is also a fundamental reason for prices to move lower and that’s a tariff on US soybeans installed by the Chinese government in retaliation for tariffs initiated by the US. The trade war that these economic powerhouses are experiencing is driving down the price of soybeans.  Soybeans are piling up in storage facilities in the US as farmers were caught off-guard by the tariffs and the cancelation of orders from Chinese buyers. What can change is an agreement between the US and China and an announcement by the Chinese government that they are lifting the soybean tariff.

Soybean Futures Daily Chart

You can also use a technical indicator as a form confirming that sentiment has become too bearish. Two good indicators are the relative strength index and the fast stochastic. Both indicators are momentum oscillators. The relative strength index measures momentum and oversold/overbought conditions based on an index that swings between 1-100. Levels below 30 are considered oversold and reading above 70 is considered overbought. The fast stochastic oscillates between 1-100 with a reading below 20-considered oversold and readings above 80 considered overbought.

If you combine a technical indicator in conjunction with a short interest rate such as the Commitment of Trader’s report, you can find specific scenarios where managed money is short and the market is oversold. These are situations that could lead to a short-squeeze especially if the fundamental news changes.

The Risks Versus the Rewards

Generally, during periods ahead of a short-squeeze, prices are trending lower. There is a very important trading concept which states that markets can remain irrational longer than most traders can remain solvent. Just because the markets are set up for a short-squeeze does not mean that the process will play out.  When you are buying a diving knife you need to have sound risk management to make sure you don’t ride a downtrend the wrong way. You can also build a position by dipping your toe in and making sure you can hold the position if it continues to trade sideways.

Natural Gas Daily Chart

The rewards can be substantial, and the upward momentum can be extraordinary. In November of 2018, natural gas experienced a massive short-squeeze, at some points rising as much as 18% per day.

Don't miss a thing!

Discover what's moving the markets. Sign up for a daily update delivered to your inbox

Latest Articles

See All

Expand Your Knowledge

See All

Top Promotions

Top Brokers

IMPORTANT DISCLAIMERS
The content provided on the website includes general news and publications, our personal analysis and opinions, and contents provided by third parties, which are intended for educational and research purposes only. It does not constitute, and should not be read as, any recommendation or advice to take any action whatsoever, including to make any investment or buy any product. When making any financial decision, you should perform your own due diligence checks, apply your own discretion and consult your competent advisors. The content of the website is not personally directed to you, and we does not take into account your financial situation or needs.The information contained in this website is not necessarily provided in real-time nor is it necessarily accurate. Prices provided herein may be provided by market makers and not by exchanges.Any trading or other financial decision you make shall be at your full responsibility, and you must not rely on any information provided through the website. FX Empire does not provide any warranty regarding any of the information contained in the website, and shall bear no responsibility for any trading losses you might incur as a result of using any information contained in the website.The website may include advertisements and other promotional contents, and FX Empire may receive compensation from third parties in connection with the content. FX Empire does not endorse any third party or recommends using any third party's services, and does not assume responsibility for your use of any such third party's website or services.FX Empire and its employees, officers, subsidiaries and associates, are not liable nor shall they be held liable for any loss or damage resulting from your use of the website or reliance on the information provided on this website.
RISK DISCLAIMER
This website includes information about cryptocurrencies, contracts for difference (CFDs) and other financial instruments, and about brokers, exchanges and other entities trading in such instruments. Both cryptocurrencies and CFDs are complex instruments and come with a high risk of losing money. You should carefully consider whether you understand how these instruments work and whether you can afford to take the high risk of losing your money.FX Empire encourages you to perform your own research before making any investment decision, and to avoid investing in any financial instrument which you do not fully understand how it works and what are the risks involved.
FOLLOW US