When stock prices start to rise rapidly, short sellers want out. This is because an investor who shorts stocks only profits when the stock goes down. However, an investors losses are a short squeezers gains, because the short squeezer is able to predict the window of time in which a stock will be on the rise, buy into the stock and sell at its peak. Sound like an appealing technique? Lets take a look at how it works — and when it fails.

Understanding Short Squeezes

Before you can completely understand short squeezes, you have to understand how the shorts, which create opportunities for squeezes, work.

If a stock is overvalued, a short seller will borrow the stock through a margin account based on a hunch that the stocks price will go down. Then the short seller will sell the stock and hold onto the proceeds in the margin account as collateral. Eventually, the seller has to buy the stock again in whats called a buyback. If the stocks price has dropped, the short seller makes money because he or she can cash in on the difference between the price of the stock sold on margin and the reduced stock price paid later. However, if the price goes up, the buyback price could rise beyond the original sale price, and the short seller will have to sell it quickly to avoid higher losses.

Example — The Anatomy of a Short Sale

Suppose that Company C was borrowed on margin and that Short Seller Bob then sold 100 shares at $25. Several days later, Company Cs stock price drops to $5 per share and Bob buys it back. In this case, Bob earns $2,000 [($25 x 100) — ($5 x 100)].

However, if the stock price increases, Bob is still liable for the price of the stock when he sells it. So, if Bob buys back the stock at $30 instead of $5 as in the example above, he loses $5 per share. That $5 times 100 equals $500 that Bob has to pay up.

But what if Bob isnt the only short seller who wants to buy back shares before they lose even more money as the stock rises? Hell have to wait his turn as he tries to sell, because others are also clamoring to get rid of their stock, and theres no limit to how high the stock could climb. Therefore, theres no limit to the price the short seller could pay to buy back the stock.

This is where the short squeezer comes in and buys the stock — while the panic-stricken short sellers are causing a further rise in price due to short-term demand. In this case, the savvy short squeezer who buys the stock while its going up must still swoop in at the right time and sell it at its peak.

Predicting Short Squeezes

Predicting a short squeeze involves interpreting daily moving average charts and calculating the short interest percentage and the short interest ratio.

Short Interest Percentage

The first predictor to look at is the short interest percentage: the number of shorted shares (short interest) divided by the number of shares outstanding. For instance, if there are 20,000 shares of Company A sold by short sellers and 200,000 shares of stock outstanding, the short interest percentage is 10%. The higher this percentage is, the more short sellers there will be competing against each other to buy the stock back if its price starts to rise.

Short Interest Ratio

The short interest ratio is the short interest divided by average daily trading volume of the stock in question. For instance, if you take 200,000 shares of short stock and divide it by an average daily trading volume of 40,000 shares, it would take five days for the short sellers to buy back their shares.

The higher the ratio, the higher the likelihood short sellers will help drive the price up. A short interest ratio of five or better is a good indicator that short sellers might panic, and its a good time to buy a short squeeze.

Daily Moving Average Charts

Daily moving average charts show where the stock has traded for a set time period. Looking at a 50-day (or longer) moving average chart will show whether there are peaks in a stocks price. To view moving average charts, check out one of the many charting software programs available. These will allow you to plot this on your chosen stocks chart.

News about industries that indicate trends are also good indicators of a potential short squeeze, so stay informed about what is happening in your stocks field.

Risks Involved

If the stock has peaked, it could fall. The success of your short squeeze will depend on your ability to sell a stock at its peak.

Employing a short squeeze strategy is not without risk, but the risk is reduced by careful study of short squeeze predictors including short interest, the short interest ratio, daily moving averages and industry trends.