CHAPTER 15 THE SHORT SQUEEZE Selling short stocks in downtrends is an essential skill and often quite a lucrative strategy.

As emphasized in the Chapter 13 on short selling, if you are a professional trader, you need to be willing to sell short at times when the market dictates. Though short selling has some special cautions, you are limiting your trading opportunities if you ignore the short side of the market. The best times to go short are when the market is in an overall Stage 4 decline, when the industry in which your stock is classified is in decline and the stock is also showing weakness. Of course, there will also be excellent opportunities to profit from short sales when a stock is trading lower without the sector or market declining as well. Unless you want to become the victim of a short squeeze, do not sell short when you think a stock is up too much, the P/E is too high or any other subjective reason. When a stock is sold short, remember that sellers represent future demand for the stock because they must repurchase shares they sold short at some future date either to close out a winning trade or to minimize their losses. The appeal of selling short is easy to understand because stocks can drop much faster and sharper than they rise. The reason is simple: Fear is a stronger motivator to take action to buy back a losing short or sell a losing long than greed is to initiate a position. As with any strategy that is a straight directional bet, there are risks involved with selling short. The biggest risk to a short seller is that the stock price rises instead of drops. A rising share price in a heavily shorted stock can often lead to dramatic upward movement as losses mount in the accounts of those who are short as they attempt to minimize their losses by buying the stock back. The main motivation to buy back the stock is the fear of unlimited losses. When you buy a stock at $20/share, your maximum loss is $20.00/share. But when you sell a stock short at $20, the potential for losses is, in theory, unlimited. The stock may rise to 40, a 100-percent loss, or it could just as easily climb to higher levels. It is the fear of such an advance that can make for an explosive upside in a heavily shorted stock. The phenomenon of a rapidly rising stock with a large short interest is known as a short squeeze.

If you have ever been short a stock that is moving higher, you understand the fear that higher prices elicit from a trapped short seller. If you find yourself in this situation, the best bet is to put your emotions aside, buy the stock back, take your loss and repeat your vow never to trade against the trend again. The unemotional willingness to cut losses quickly is the sign of a true professional. It always boggles my mind to see a stock in a clear uptrend with a large short position that was established at lower prices. What is the logic of stepping in front of strong directional momentum in hopes of catching the ultimate top? Instead, why not safely wait for a downtrend to fully reveal itself before initiating a short position?

The Short Interest Ratio Before exploring the actual dynamics of a short squeeze, lets cover some key terminology and learn how to analyze short interest data. The Short Interest Ratio (SIR), or days to cover, is the number of shares sold short (short interest) for a particular stock, divided by its average daily volume over the previous two weeks. The SIR is interpreted as the number of days it would theoretically take to cover (buy back) the shares sold short based on the average daily volume. I use the term theoretically because, in reality, the shorts would not be the only participants in the market. As a result, it normally takes longer to liquidate (buy back) these short positions. The higher the SIR, the more difficult it is for shorts to cover as their buying will create higher prices, thus sabotaging their own positions. Examples of how SIR plays out mathematically: If the stock had a short position of 4,800,000 shares and an average daily volume of 800,000, the SIR would be 6.0. This means it would take six full days of average daily volume for the short sellers to cover their bearish bets. If the same stock traded an average of 2.4 million shares per day, the short interest for the stock would be 2.0, or two days to repurchase. Using the same stock, but with average daily volume of just 200,000 shares, the SIR would then be 24, meaning it would take 24 days of buying to cover the positions. From a trapped shorts standpoint, the lower the SIR, the better. However, from a contrarian standpoint, a higher SIR is desirable because it is more difficult to cover the position; thus, the resulting buys would have the potential to create significant upside momentum.

It is important to note that a large outstanding short position or short interest ratio by itself is not a reason for buying a stock in anticipation of a short squeeze. The informed trader will find an edge when there is a preponderance of indicators leading to a price advance. Nonetheless, it is an excellent gauge of potential demand for a stock which should be a part of every traders arsenal. Short sellers who initiate large positions against a stock typically are sophisticated speculators who have done extensive research on their targeted company and are often right. Many times those who sell short have the right idea fundamentally, but their timing is off. The correct time to sell a stock short is when it is either in or entering a downtrend. When a short position is initiated in a stock that is trending higher, there is real potential for losses to spiral out of control for the shorts. When Does a Short Squeeze Occur? A short squeeze develops when those who sold short the stock, expecting it to decline in price, change their minds about the trade and attempt to cover their position before the market advances and large losses accumulate. Short squeezes often occur because of a news event that changes investor perception on the worth of a particular company. A short squeeze also can be created by long holders of the stock attempting to push the price higher to tap into the emotional buying that trapped short sellers can provide. If you have ever been short an advancing stock, chances are there was a point at which you became afraid to continue holding that position. To eliminate the mounting losses and the emotional trauma of holding a big loser, you became a panicky buyer. This is not uncommon. It is this buying that makes the stock advance at a rapid pace as pressure of holding a losing position mounts, and the short seller gets squeezed. There are times when short sellers find themselves in a position of being forced by their brokerage firm to repurchase shares that have been sold short. There are two reasons for forced buy-ins. The first is from margin calls. When losses in a short position have gone so far against a customer that their equity levels fall below exchange requirements, the brokerage firm is required by regulatory bodies the SEC, NASD, etc. to demand the customer either to deposit more margin money or buy back the shares. Never allow yourself to be in the position of a margin call whether you are trading long or short positions. If you ever receive a margin call on a long or short position, it means you need to work on money management.

The other reason for a forced buy-in of a short position comes when the shares shorted are no longer available to be borrowed against. When long holders of the stock who have allowed shares to be borrowed for a short position liquidate their holdings, short sellers who have borrowed those shares are left with an illegal naked position. When this occurs, it is the responsibility of the brokerage firm to demand that short sellers either find other shares to borrow, or force customers to buy back the stock, If to the short seller cannot locate other shares to borrow, the short seller is required by securities regulations to repurchase shares or the brokerage firm will do it for them. There is also a more sinister way in which the short sellers can be targeted for a squeeze with a forced buy-in. If large long holders wish to inflict maximum damage on short sellers, they will allow their stock to be borrowed until a time where the buyers have taken control of the trend. If an institution that is long (lets say one million shares) of stock suddenly demands that the shares loaned out be delivered back to that firm, the borrowers are stuck looking for new shares to borrow. Or they must cover the short position by repurchasing the shares they are short. Either way, its a difficult situation. This is particularly effective at putting pressure on shorts because of its cold-hearted implementation. In effect, the long holder set the shorts up to be squeezed. Loaning shares to be shorted is a source of revenue for some brokerage firms that can charge customers substantial fees for access to long positions in highly demanded stocks. Most investors purchase stocks in street name, which means that the brokerage firm holds the shares. If shares are purchased in a margin account, it allows the brokerage firm to hypothecate, (lend out) these shares to other customers who may want to establish a short position. An alternative is to purchase shares and request that an actual stock certificate is issued, but this is rarely done. It is possible to request shares to be held in street name but not be allowed to be borrowed for short positions. If you open a cash account without margin capability (and therefore a hypothecation agreement), your shares will not be available to be borrowed. Another way to prevent your long position from being borrowed is to enter a good-until-cancelled (GTC) sell order on the stock at a price you believe has little chance of being transacted. For instance, if your stock is trading at $20, you may enter a GTC order to sell the shares at $50. Because you have a pending order

to liquidate your long position, the brokerage firm cannot lend out the shares in your account. Short Squeeze Play #1 I consider there to be two different types of short squeeze plays. The first is what I call a knee-jerk emotional short squeeze (Figure 15.2). This squeeze occurs in a declining stock with a large short position. When a stock in an established Stage 4 decline is accompanied by a large short position, short sellers are in control of the trend, and their accumulated profits make them less likely to panic and buy at the first signs of strength. Keep in mind that short sellers can be some of the sharpest minds on the planet, and they may be right. When prices are declining, they can dig their heels in, staying short until, in the most severe down market, the stock becomes delisted if the company declares bankruptcy. Stage 4 stocks can experience quick and large rallies, but those short-term bursts higher typically will fail as longer-term selling pressure is too strong to overcome. It is common to see an emotional burst of buying by shorts after a stock has sold off hard for a week or more. These stocks exhaust all sellers from the market after a relentless fearful selling campaign. In addition, declining prices attract momentum short sellers who pile on extra shares of short stock near a short-term low, their confidence buoyed by short-term profits. A simple absence of further supply will push shorts to begin to cover their shares, but with limited supply their buying forces the stock higher. The initial strength brought on by these short sellers then attracts short-term sidelined cash to the stock in search of quick longside profits in the longer-term downtrend. As short and long traders compete for limited supply of shares, it can send the prices quickly higher. Indeed trading these short-term rallies can result in great short-term trading gains, but because the dominant trend of the longer timeframe is lower, they are very risky trades. They are best left to the most risk-tolerant traders who specialize in the shortest timeframes. The best course of action is to stay with the primary trend rather than charter these risky waters. Getting a Broader Sense of Short Action It is useful to know that when a stock is sold short, exchanges mandate the brokerage firms to record it. Twice each month, the firms tally all short sales not covered by their customers and send the data to the various exchanges. The exchanges then combine the firm data and publicly disseminate the information the on the 15th and last calendar day of each month. Take a look at Figure. 15.1 below

to get a sense of the data. My favorite free site for finding short interest data is www.nasdaq.com

Figure 15.1 Short interest data table. The numbers (9-1) in the left-hand column provide a visual reference (on Figure 15.2 below) of when the short sellers added shares. 123Date: Bi-monthly data date Short Interest: Total number of shares sold short but not covered AverageVolume: Average number of shares traded per day over 2 weeks (rolling) Short Interest Ratio (also referred to as Days to Cover): The number of days it would take short sellers to cover their bearish positions, it is calculated by dividing the short interest by the average daily share volume of the previous 2 weeks. Volume Weighted Average Price (VWAP): Average price at which the stock traded during the prior period, it offers an idea of the average price at which short sellers may be involved. (I have added the VWAP info to this table as I refer to it often; at www.alphatrends.net.)

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Figure 15.2 The stock above shows the stock whose data is represented in Figure 15.1. RealTick by Townsend Analytics. Note that as the stock above (Figure 15.2) broke down, the short sellers became more aggressive, raising their bet against the stock from 11.6 million shares to 21.2 million (Figure 15.1). During period 7 on the chart you can see that the large volatility motivated shorts to cover approximately 1.2 million shares. As the stock continued lower, the shorts added even more shares. Short Squeeze Play #2 A second short squeeze is one I call a structural short squeeze. It occurs when an uptrending stock has a large short position which was initiated at lower levels. By combining the information from the short interest tables (Figure 15.3) and the price chart (Figure 15.4) below, you can determine the approximate level where the majority of the outstanding short positions were initiated. Using this information to recognize the approximate price at which a large short position begins to lose money lets you hone in on stocks that may be poised for a squeeze. If the majority of short positions were initiated at lower levels, the growing losses

in a rising stock motivate short sellers to reconsider their positions and repurchase the stock. The short covering becomes an additional source of demand which adds further pressure to the average short seller. This type of squeeze setup can lead to substantial moves higher as it is based on a large group of participants being wrong in a stock with upward momentum.

Figure 15.3 The table above should be viewed with the chart in Figure 15.4.

Figure. 15.4 A structural squeeze develops as a stock like this one breaks out to new highs, leaving the large short position in a losing scenario. RealTick by
Townsend Analytics.

The stock in Figure 15.4 represents what looks like an excellent candidate for a structural short squeeze. The VWAP for the entire period 1-10 was 42.37 (long horizontal blue line), which means that at the current price the average short seller was down approximately $3.00/share. A closer examination of the short interest shows those who initiated a position in period 8 (12/31 to 1/15 represented by a shorter blue horizontal line) sold short just less than two million shares at an average price of 40.53. With the stock nearing highs and the 10-, 20- and 50-day moving averages all advancing, I would be nervous if I was short this stock. Finally, here are some general points to help you determine which stocks may become squeeze candidates: 1- Uptrend on the daily timeframe. At a minimum, the stock must be above the rising 50-day moving average. Stocks at or near all-time highs are best because there is no real motivated source of supply when all the longs are in a winning position. If the stock is in a downtrend, it is not a good squeeze candidate, as short sellers are in control and have no reason for aggressive repurchases. 2- Absence of any hedging vehicles. Some common ways for short sellers to hedge bearish bets are with options, a different class of common stock, warrants, convertibles, preferred stock or any other hedge products. If there is an inability to hedge short exposure, it will leave the short seller in a more vulnerable position. 3- Short interest should be high relative to average volume; the higher the SIR, the greater the difficulty short sellers will have in the repurchase of their shares, thus resulting in higher prices. 4- Level of potential squeeze. Check to see approximate level at which the majority of shorts were initiated; this can be approximated with the Volume Weighted Average Pricing (VWAP) tool. When the stock rises above this level, the average short seller is losing money; that makes the shorts vulnerable to a squeeze.

Stocks with double sources of demand (longs and shorts) and tight supply (especially if the stock is at an all-time high) can lead to excellent trending opportunities. Short sellers are usually very savvy speculators. However, like any group of market participants, they arent always right. When shorts are wrong about the direction of a stock, their move to cover can lead to some excellent shortterm profits for traders who are able to recognize the squeeze situation developing.

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