How to Analyse Short Sale Volume in Trading?

Short sellers are only in a position to make money when the price of the company they are shorting decreases, therefore when the value of the stock begins to increase quickly, they want out. When stock prices go up, they might potentially lose everything. On the other hand, their suffering can be an opportunity for a short squeezer.

Short-Squeeze Analysis

You first need to be familiar with the fundamentals of short selling before grasping the concept of short squeezes.

A short seller can borrow shares of a company via a margin account if they think the stock is overpriced and the price of the shares is likely to decrease. The short seller then profits from the sale and keeps the money in a margin account. At some point in the future, the seller will be required to repurchase some shares. When the stock price that was sold on margin is higher than the price of the stock that is paid for in full later, the short seller realizes a profit. This profit is attributable to the price difference between the stock sold on leverage and the stock paid for in full later. However, if the price continues to grow, the repurchase price may increase to a point where it is more than the initial selling price. In this case, the short seller may be forced to sell the asset immediately to prevent even greater losses.

A Simple Squeeze: an Example

Let us say a trader used margin to borrow money to buy Company C shares, then sold one hundred of those shares for $25 each. After a few more days have passed, the stock price of Company C drops to $5 per share, which prompts the trader to purchase it back. In this scenario, they make a profit of $2,000, which is calculated as follows: ($25 x 100) minus ($5 x 100). On the other hand, the short seller remains responsible for the full sale price of the stock even if the company's price rises. Therefore, the trader will incur a loss of $5 per share, which amounts to a total of $500 if the stock is bought back for $30 rather than $5 (as shown in the previous case).

However, if the stock price increases, the short sellers may wish to cover their positions by purchasing back shares. There is no limit to how high the stock may soar when brokers launch margin calls pushing short sellers to purchase to cover their positions. In this scenario, they will have to compete with one another since other people are also eager to buy shares to cover their short sales. Because of this, there is no upper limit to the amount the short seller may pay to purchase the shares back.

The short squeezer enters the market at this point and purchases stock shares, doing so when the distressed short sellers are driving up prices further owing to increased demand in the near term. A person who engages in short selling needs to anticipate and recognize potential short squeezes and choose the optimal moment to sell a stock that is either at or very close to reaching its highest point.

Understanding and Anticipating Short Squeezes

The interpretation of daily moving average charts and the computation of the short interest percentage and the short interest ratio are required to anticipate a short squeeze.

Short interest percentage

The first factor that should be considered is the short interest percentage, calculated by dividing the total number of borrowed shares by the total number currently in circulation. For illustration's sake, let's say that short sellers have sold 20,000 shares of Company A stock, and a total of 200,000 shares of stock are outstanding. The short interest percentage in this scenario is 10%. If this proportion is large, then a greater number of short sellers will compete with one another to purchase the stock back if its price begins to climb.

Short interest ratio

The short interest ratio is calculated by dividing the total number of short positions by the company's average daily trading volume (ADTV) under consideration. If short sellers had 200,000 shares of stock and the average daily trading volume (ADTV) was 40,000 shares, it would take five days for the short sellers to buy back their stock.

A greater ratio indicates that short sellers are more likely to contribute to a price increase. High short interest to total interest ratio (five or more) signals that short sellers may panic.

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Daily moving average charts

Charts using daily moving averages show the prices at which a stock has traded over a certain time. If you look at a chart with a moving average of at least 50 days long (or longer), you will be able to determine whether or not a stock's price has reached any peaks. Moving average charts can be viewed using one of the several charting applications. Using this, you may adjust the stock's chart appropriately.

Staying up to date on what's happening in your stock industry is essential for helping avoid being caught in a short squeeze, which news headlines may trigger.

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Summary

The capability to successfully time a short squeeze may be a highly profitable technique, but a significant level of risk comes along with the potential for gain. Accurately estimating when a peak will occur is not a simple task. A trader interested in making a profit from a possible short squeeze should do an in-depth analysis of several short squeeze predictors, such as short interest, the short interest ratio, daily moving averages, and industry trends.

Disclosures

When short selling there is no limit on how high a stock price could rise so the potential loss is unlimited. Other risks include dividend risk and margin risk, this strategy is not appropriate for all investors.

Margin trading entails greater risk, including, but not limited to, risk of loss and incurrence of margin interest debt, and is not suitable for all investors. Please assess your financial circumstances and risk tolerance before trading on margin.