Profiting from Short Squeeze When Trading CFDs

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Profiting from Short Squeeze When Trading CFDs

A short squeeze is a risk associated mainly with short selling on stock or indices and means that short sellers are forced to get out of the market (thus closing sell orders with buy orders), driving the price even higher. When shorting the stock market, there is an opportunity cost associated with this move, given that even if the stock goes down to zero, you’ll only make 100%. On the other hand, the upside potential is unlimited, since it can multiply by several times.

How to profit from a short squeeze situation

All the tips we’re about to share should be applied mainly for trading CFDs based on shares or indices. But before we get into that, we must talk briefly about the favorable market context. When a particular asset (stock or index) start to move lower, it could mean that some of the market participants are starting to trade reversals.

Usually a risk (financial, political, economic, etc.) arises and market participants start to sell on fear. However, if we look back over the past 50 years, even the largest market drops look like minor setbacks now.

It’s critical that you manage to stay objective and analyze the situation using concrete information (not fake news) in order to assess whether the weakness is short-lived or not.

Steps you need to take

Over time, you’ll manage to develop some skills that will help find situations like these, but until then, you should focus on following a few simple principles:

  1. Find situations where there’s a short-term weakness against long-term strength: the current situation in the US stock market is a very good example. From time to time, risk situations arise but the overall financial conditions (a.k.a. the central bank printing money) support the stock market to go higher.
  2. Wait until the market drops towards a key support area (previous high, moving average, Fibonacci retracement level, etc.). Here a good example of the Dow Jones Industrial Average that occurred recently:

As you can see the Dow started to drop once tensions with Iran started to build up. The index reached the 4h chart 200 simple moving average and then the short squeeze began, erasing all the losses and driving the price towards new record highs.

3. Don’t forget about risk management – make sure that you have a stop loss for each trade and always target a profit that’s at least twice bigger than the risk you take.

Summary

Short squeeze situations turn out to be a great opportunity to get long the stock market right after a retracement and could offer important trading opportunities over the long-term. Looking constantly at the charts you’ll find plenty of similar opportunities like the one we’ve shown.

How to Profit from a Short Squeeze

Short squeezes associate typically with short sellers – a type of traders that players on the market do not like too much. However, short sellers make handsome profits if they take advantage of the short squeezes correctly. These traders act somewhat against the general rule of investing. Instead of buying low and selling high, just like everybody else, short sellers first sell the assets and wait (hoping) to repurchase the assets when the price falls. To understand how short sellers operate and how to profit from short squeezes, we will discuss some principles in detail.

How do Short Sellers Operate?

Profiting from short squeezes and shorting the market usually generates negative sentiments. However, some of the most successful traders on the market are shorting stocks in their benefit.
In essence, the short seller builds the trading strategy around making a profit when the assets’ prices fall rather than rising. The working chain is easy to understand:

  1. The seller believes the price will drop (considering the assets are overvalued and likely to decline in price).
  2. Next, the trader borrows shares for instance through a margin account from a broker.
  3. The trader then sells the shares and gets the money from that sale. At this moment, the trader has a short position on the market.
  4. If the asset’s price falls as anticipated by the trader, then the next step is deciding whether to buy back the shares at the current declined price and return them to the broker that lent them.
  5. If the decision takes the buy-back path, then the trader gains from the variance in the price of the assets (defined as the difference between the amount of the asset sold on margin and the lower price paid later).

The issue of the pricing going up instead of down is of extreme importance: if the trader is wrong and the assets’ values go upwards, he/she will have to pay more money to buy back the shares, as the prices can often rise beyond the original sale value. In other words, the short seller has to sell quickly to avoid more significant losses.

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When short sellers are wrong, long investors have a field day. Short sellers start to “cover” (buy back their assets). In turn, it leads to the stocks raising more, driving more short sellers to cover. If the shares phase into a significant rally, panic buying ensues, leading to the short squeeze. Naturally, the phenomenon amounts to stronger profits for the long investors who hold on to their shares for the long run.

The Short Squeeze: Mechanism

To make things more precise, the short squeeze occurs when short sellers trigger a price increase on an intensely shorted stock. To close their short positions, sellers have to buy to cover, creating strong demand. Then, they “squeeze” each other out of their short positions in a race to get out as fast as they can, leading to even higher spikes in the price. The squeeze gets even more prominent with the more traders trying to limit their losses and cover their shorts.

How to Profit from a Short Squeeze

Short squeezes usually have a catalyst – an event leading to the price going upwards, against the short sellers. It can be a company’s announcement or a macroeconomic occurrence. For you to profit from short squeezes, you need to predict them. To do that, you need to use the best CFD and Forex trading account and software, as you need to interpret a series of indicators, understand the market sentiment, following significant industry trends, and crunch big data comprising news, social media signals, and more.

  • Short Interest Percentage: you can calculate it by dividing the number of shorted shares of a company by the number of shares outstanding. The general idea behind the short squeeze is this: the more traders are short, the more the price will likely bounce.
  • Short Interest Ratio: you can calculate this number by dividing the short interest by the average daily trading volume of the stock that interests you.
  • The Daily Moving Average Chart: this tool helps you see how the price of the stock that piqued your interest moved during a predefined period (let us say the past 50 days or more). You should use your preferred trading online platform for the MA and plot the results into your stock’s chart.
  • News headlines: as we said, short squeezes have an impetus moment that cascades afterward. Let’s say that you follow a company that has overall poor results. Short sellers bet against it, as the trend shows the company is on a downfall path. However, the brand announces the release of a revolutionary product and share prices go up. Short sellers are stepping each other on their toes to cover while you can make a profit from this unexpected piece of news.

When to Make Your Move

  • Upon making these calculations, you have to know that the higher the interest ratio is, the higher is the probability that short traders will push the price upwards.
  • Orient yourself towards a short interest ratio of five or less – it means that soon, short sellers will panic and it is a good time for you to trade into a potential upcoming short squeeze.

Bottom Line

It is rather difficult to time perfectly a peak against the short sellers. If you are looking to make a profit from a potential upcoming short squeeze, you have to dedicate time and effort to working with charts and indicators, exploiting your trading account to its max potential, research market trends, companies’ historical ups, and downs, different sectors’ trends, and more.

Nevertheless, if you manage to master all these factors, profiting from short squeezes may prove a very lucrative business.

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