How Can You Profit From A Short Squeeze?

Markets may be unpredictable. You never know when emotion may take over and carry you in an unexpected route. During a trend or even a range bound condition, prices of a single investment may not fall lower despite the underlying background. When everyone is pessimistic and negative emotion is exaggerated, a short-squeeze might begin, sending prices soaring. There are various techniques to determine whether or not individual players are underutilized. You can rapidly assess whether the market is offside by employing a mix of regulatory reporting methods and technical analysis.

What is a Short Squeeze?

A short squeeze is a situation in which a stock, index, commodity, or currency rises upward, causing short sellers to leave their holdings. The increase of upward pressure fuels irrational feeling, driving prices higher. The word refers to a scenario in which short sellers are being forced out of their short holdings. When you short an asset, you are often betting that its price will fall. When you short a regulated security, such as a US commodity or share, your short position is notified to the market's authorities. Short holdings in OTC currencies or CFDs are often not disclosed. When you short a stock, you must borrow it from someone else who owns it. The objective is to purchase the stock back at a reduced price and return the debt used to borrow the shares.

What Causes a Short Squeeze?

The drive for the squeeze might originate from fundamental causes, where a comeback is justifiable, or negative sentiment becomes unsustainable, resulting in illogical price momentum. A basic drive might be economic or macro information. During a short-squeeze, most short positions are closed at a loss.

How Can You Tell if the Market Is Oversold?

You may use certain methods to examine how the market is positioned before a short-squeeze begins and prices begin to increase. One of the greatest tools, for example, is the Commitment of Traders report issued by the US Commodity Futures Trading Commission. Unless there is a holiday during the week, this report is published every Friday. The report includes particular holdings for each investor. Investors are classified according to their size and employment. Swap traders, for example, are reported separately from individual investors. Swap dealers offer liquidity to investment managers and business companies. Managed money funds and individual investors are self-explanatory.

Short interest information for equities is easily accessible. All short interest holdings held by FINRA member firms must be reported twice a month. The SEC also mandates short-term interest reporting. Member businesses are regarded members of a stock exchange, such as the NASDAQ or the New York Stock Exchange. In general, the exchanges publish short interest twice a month. The first time was in the midst of the month, and the second time was toward the end of the month. The exchange has a system in place to manage inter-month stock splits.

How Do You Trade a Short-Squeeze?

Your aim is to buy an asset when you feel that market participants are overreacting and that negative sentiment is exaggerated. As previously said, you may utilize tools such as the Commitment of Traders report of exchange short interest to identify whether there is a big short interest in a stock or commodity.

The table above depicts the disaggregated Commitment of Traders data for a mix of futures and options for the date ending November 20, 2018. Each futures contract is reported individually. The soybean contract traded on the Chicago Board of Trade reveals that managed money is short 132K contracts and long 72K contracts. The number of hedge funds that are short is approximately twice that of hedge funds that are long. This indicates that speculators are relatively sure that prices will continue to fall.

There is also a basic cause for prices to fall, and that is a tax on US soybeans imposed by the Chinese government in retaliation for tariffs imposed by the US. Soybeans are being pushed down in price as a result of the trade conflict between these two economic powerhouses. Soybeans are stacking up in US storage facilities after farmers were caught off guard by tariffs and the cancellation of deals from Chinese customers. What can change is an agreement between the United States and China, as well as a statement by the Chinese government that the soybean tax would be lifted.

You may also use a technical indicator to determine if mold has grown too pessimistic. The relative strength index and the quick stochastic are two useful indicators. Both indicators are momentum oscillators. The relative strength index monitors momentum and oversold/overbought circumstances using a 1-100 scale. Levels below 30 are considered oversold, while readings over 70 are considered overbought. The fast stochastic oscillates between 0 and 100, with values below 20 considered oversold and readings over 80 considered overbought.

When you use a technical indicator in combination with a short interest rate, such as the Commitment of Traders report, you may identify certain circumstances in which managed money is short and the market is oversold. These are the kinds of scenarios that might lead to a short squeeze, particularly if the basic news changes.

The Risks vs. the Rewards

Prices are often drifting downward during times before a short-squeeze. There is an essential trading notion that claims that markets may stay irrational for a longer period of time than most traders can remain solvent. The fact that the markets are set up for a short squeeze does not guarantee that it will occur. When purchasing a diving knife, you must use solid risk management to avoid riding a decline the wrong way. You may also develop a position by putting your toe in and ensuring that you can maintain the position if it continues to trade sideways.

The benefits may be considerable, and the upward momentum can be tremendous. Natural gas underwent a major short-squeeze in November 2018, with prices jumping as much as 18% per day at times.