Imagine a short trade with a lot of participants; a large number of short sellers have borrowed a multitude of stock they must eventually return. When something unexpectedly causes the price of these shares to rapidly rise instead of fall, more buyers may enter into the trade assuming the momentum will continue. This is when something called a short squeeze may occur.
This phenomenon gets trickier when a key level coincides with a mental level, a number where many short sellers are inclined to tap out. It could be a previous high price of the day, or simply a round number that too many traders have aligned themselves with for the trade.
And because the market responds to the existing bids and asks, the high demand for shares to cover the borrows can spike the stock’s price. Further, when you consider the other side of the market, long-biased traders notice a stock trending up and decide to jump in. They view it as a breakout worth buying into, especially if the ticker stands out in the overall picture. This, in turn, drives the demand for shares even higher, increasing losses for those who borrowed the stock.
This is where the term “short squeeze” comes from; the stock price skyrockets, figuratively squeezing all short sellers and making them lose money. And while the price usually drops later, the damage has already been done.
There’s no way to predict a short squeeze. However, there is a pattern that can be observed. For example, sometimes a squeeze happens when short sellers get too confident after seeing a stock continuously fail. Nevertheless, that factor is not a definitive confirmation on its own. You also need to acknowledge the interest of long buyers for the ticker in order to get even more momentum. In that case, a short squeeze can potentially happen.
On the other hand, it’s important to note that nothing is guaranteed when it comes to day trading. If stock doesn’t get enough traction, typically, nothing drastic happens. However, if the squeeze occurs after all, it can hit your account hard.
At Cobra Trading, we want our traders to succeed. As a broker that specializes in locating non-easy-to-borrow stocks, we have a lot of clients who are short-biased traders. We want short sellers to be aware of all risks involved and prepare them to protect their accounts and day-trading careers.
That’s why we provide educational resources on risk management, developing a day-trading strategy, and other essential concepts and tools that can help assist you on your trading journey. And if you’d like to open a trading account with Cobra Trading, you can start the process right now.