I have listed yesterday the top 100 stocks with the highest short interest ratio, and in the post, I’ve briefly discussed the concept of a short squeeze, I would like to discuss it more. I will start with the definition of a short squeeze, and then I will discuss in details how it happens, I will then provide some examples, and finally I will point out which stocks are generally more vulnerable to short squeezes.

Definition

A short squeeze is a substantial spike in the price of a stock (usually 10% or more) when investors shorting the stock start covering their positions (in other words, buying back the shares they borrowed and sold immediately).

How it happens

Shorting stocks is a very risky and dangerous game. Investors shorting stocks know that they are betting against the very long term trend of the market when they short stocks (it is a proven fact that markets can only go up on the very long run). Usually, investors short a stock when they see that:

– The company consistently delivers bad news.
– The company has no future.
– The stock technicals are moving from bad to worse.
– A lot of other investors are shorting the stock (follow the herd).
– There is a general sentiment that the stock is overvalued (this applies a lot to commodity ETFs and commodity related stocks, especially those related to gold and oil).

When all of the criteria above apply to the same stock, then the stock will be heavily shorted, and the stock price will decline, attracting more investors to follow the trend and short the stock in order to make money themselves (by the way, shorting a stock will lower its price because it’s considered a sell transaction). Investors already shorting the stock will short even more shares of the same stock. Eventually, the stock will reach a point where a substantial percentage of the daily volume is short selling, and this is where the game becomes dangerous. The thing is, for everything and everyone in life, there are ups and downs, the same thing for stocks, a stock cannot continue going down forever (unless, of course, the company goes bankrupt), and it cannot go up forever. The trend of a stock can be reversed in an instant by many factors, including:

– The company suddenly reports higher than expected earnings.
– A larger company expresses interest in buying the company (maybe it’s a rumor or maybe it’s true, but who cares?).
– Insiders start buying shares from the company (a sign that they know or feel something good is going to happen to the company).
– Institutional investors, such as large investment banks, start buying shares in the company.

When any of the above happens, the stock will rise, despite the shorters’ attempts to maintain the downtrend by shorting even more stocks. At one point, automatic orders to cover losses will be triggered. Here’s how:

Let’s assume that Investor A shorted 100,000 shares of NFLX when it was at a $100 back in July of 2010, the investor assumed that NFLX cannot sustain its growth, and the stock price of a $100 is overvaluing the company. Investor A, to protect himself, created a stop loss automatic order to buy back the stock if it goes up more than $110. Investor B also shorted 100,000 of NFLX during the same period, thinking that the stock can go nowhere but down. Investor B was able to tolerate a bigger loss, so he created a stop loss automatic order to buy back the stock if it crosses the $120 mark. NFLX, probably the most dangerous stock to short, instead of going down, went up $10, and triggered the stop loss order of Investor A, who had to buy the 100,000 stock he earlier borrowed. Now, when Investor A and other similar investors had their stop loss orders triggered, they inadvertently raised the stock price again, pushing it over $120, which triggered Investor B’s stop loss order, who had to buy back the stock, thus pushing the stock price even higher. This can easily become a vicious circle for shorters, where an investor short covering will trigger the stop loss order of another investor, until the short interest ratio will be reduced to almost nothing. What makes things even worse is that regular investors start seeing some value in the stock and they start buying it, in masses! The stock can jump over 50% in one day if this situation happens.

Examples

There are many examples of short squeezes, the NFLX one above is somewhat real, but here are a couple of recent examples:

– BIOS (BioScrip Inc.): Take a look at the below chart

The stock was heavily shorted before it jumped on good news, I remember that the stock jumped 60% in one day, that’s not very normal!

– GG (Goldcorp Inc.): Again, take a look at the below chart

GG is the stock of a gold producer, so it’s directly affected by the price of gold. You can easily notice that there were short squeezes when investors thought that gold was way overpriced and so it has to fall down, and yet, because of different factors (including instabilities in the Middle East and the weak US dollar), gold jumped, thus pushing many investors to cover their positions.

Which stocks are typical candidates of short squeezes?

Small cap stocks are at a much higher risk of short squeezes than blue chip stocks, this is because…

– The volume on small cap stocks is so low that it’s easy for a small number of powerful investors to short a significant percentage of the daily average volume.
– The volatility of blue chip stocks is much lower than that of small cap stocks. When was the last time you saw BAC going up 60% or going down 70%?
– Small caps stocks are cheaper and thus easier to short.

In my opinion, a short squeeze is the market’s punishment for those trying to benefit from the misfortune of others. Everyone should understand that stock trading is not a zero sum game (people don’t have to lose money so that others make more money), and there’s enough money for everyone.