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What is the Short Squeeze In Technical Analysis?

BitForex Editor
Nov 06, 2020

Between October and November in 2008, a short squeeze scenario played out. This market situation involved Volkswagen, Porsche, Lower Saxony, and the short-sellers in VW's stock. And this is how it happened that year.

Porsche and Lower Saxony held shares in Volkswagen's market, they had 31% and 20% respectively. Meanwhile, short-sellers had 13% of the shares on loan to them. The short sellers must have taken Porsche’s statement earlier that year into consideration.

Around March 2018, Porsche made it known that it would not be purchasing any more than it already had. However, in October, Porsche purchased more so they were having a total of 73% in VW's shares. Since Porsche and Lower Saxony weren't going to sell their shares, the shorters were in trouble.

Also, there must have been panic-buying as the Volkswagen stock rose sharply. It was a gigantic spike. The price went from 200 per share to 1000 per share.

Short squeezes happen in financial markets throughout the world and that which occurred with Volkswagen in 2008 was an unforgettable one. So this scenario is one that any seasoned investor should be wary of.  However, when it comes to a short squeeze, short-sellers are the most active participants.

In this article, we would discuss all you need to know about the short squeeze. You will get a simple definition of the short squeeze. This short squeeze scenario can go two ways. That is, it could benefit some investors and be detrimental to others. If the short squeeze wouldn't be good for you, there are ways to detect it before it happens.

To detect short squeeze, you'll need to determine any of the following:

1.Short Interest Percentage

2.Short Interest Ratio

3.Daily Moving Average Charts

These methods require that you either calculate using figures or read charts.  Hence, short squeezes are technical business. And that brings us to what short squeezes and technical analysis have in common. The more of a long term trader you are, the less a short squeeze impacts your analysis.

The reason is that short squeezes are more as a result of short-covering than ordinary market action. Short coverings involve short-sellers buying investments when they observe a potential loss from their initial short positions. Because of this, the short term spikes caused by a short squeeze does not affect the long term trend of the market.

What is a Short Squeeze?

To cap it, you can detect the short squeeze better using technical analysis.

Now, besides the Volkswagen situation here is a proper definition of a short squeeze. A short squeeze is a market situation where a stock, currency, or asset rises sharply, coercing traders who invested short to buy because they risk losing their investment.

The rush to buy back puts more pressure on the market to surge upwards. It is important to understand short squeeze because it spells doom for short-sellers and it happens quite often in the market. However, some short squeezes are greater than others. Short sellers usually open positions to go short when they see the potential for a market to dwindle.

The resulting spike in price could be a fake-out and last a small period. Otherwise, it could be lasting and see a ‘shorter’ take terrible market hits.

Benefiting From a Short Squeeze 

The market can go two ways in any market situation. And a short squeeze results in one swift upward direction. If an investor predicts that a short squeeze would happen, he can invest to take advantage of it. Since the short squeeze is a sudden jump in price there's usually a lot of money that you can make by trading it.

We have already discussed how the detection of a short squeeze is heavily dependent on technical analysis and that there are three common ways to do it. Here we'll discuss in short brief and easy to understand ways that you can determine a short squeeze market.

Short Interest Percentage

To arrive at this percentage, you need to divide the amount of sold shares by the total outstanding shares in any particular market. Multiply the result by 100. This is most applicable to company stocks where you can easily determine the figures involved in the stock. For instance, let's use a certain hypothetical company.

They have 40,000 shares shorted and the total outstanding shares in that company's stock are 200,000. The short interest percentage would be 20%. The higher the percentage, the higher the rush by short sellers to buy, and the more likely that a short squeeze is imminent.

Short Interest Ratio

To get this, just divide the amount of stock that sellers are shorting by the average trading volume per day. The higher the ratio you get from this calculation is, the more likely the possibility of having a short squeeze.

Daily Moving Average Charts

Moving averages can help experienced technical traders to know where the market has been during a period. Hence they would be able to determine whether a shirt squeeze is imminent or not.

Even when short sellers buy the market in such a rush,  it is risky because the decision is usually based on mass buying more than any other thing. And only investors who have other solid reasons for buying might be making a well-informed decision.

Therefore have it at the back of mind while making a short squeeze the backbone of your technical analysis that although the reward potential is high, so also is the risk involved.

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