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I hesitate to offer suggestions whether or not longs should sell, or shorts should buy, but it seems to me that those who are currently in a short position with Sirius XM (SIRI) could very well find themselves in trouble if they are not in trouble already.

The recent move up from $2.10 to today's hit of $2.60 was so rapid it seems to have caught many people off guard. I'm receiving message after message in my inbox from people who are frustrated that they were away for a few days or a week, and missed what has been the run they have been waiting for all year because they had sold out on the downturn and had not bought back in. While it can be frustrating for a potential long to miss a run up of 50 cents, imagine the frustration of the shorts, who are now under water by 50 cents or more?

To be fair, there has been considerable volume recently, and this has been more than enough for shorts to cover, but I don't think all shorts have been so lucky. I believe that $2.50 was expected to be a major point of resistance, and a pullback was expected, at least in the short term. The longs were expecting such a pullback and have been lightening or exiting their positions entirely at this price point. The shorts? It's very likely that they have been doing what is called "averaging up."

The same way a long will average down, buying as a stock drops in order to bring their average cost basis down, and capitalize on a future bull run, a short will average up. By being on the wrong side of the trade in a bull run as a short, you want to bring your average short position *up* as high as possible in order to increase your gains on a pullback, or raise the price level at which you can cover.

The problem? It's a risky venture. If I short 100 shares at $2.10, and then again at $2.30, while my average is now $2.20, I am now short 200 shares at $2.20. If the price increases to $2.50? To bring my average up to $2.35 I have to short 200 shares at $2.50 leaving me with 400 shares short at $2.35. Next step? I have to short another 400 shares. It effectively doubles every time as a short gets further and further under water and becomes almost exponential and thus unmanageable after just a few instances of chasing the price.

This is how a short squeeze can happen. It's a bubble, and at some point it has to pop.

So what is the problem for the shorts in Sirius XM? Liberty Media (LMCA).

Liberty has been on a buying spree lately and likely will not stop until it reaches a 49.9% stake. Even then, they may not stop as it pursues control of Sirius XM and take their position as high as 54% or above in order to insulate itself from the effects of dilution from employee stock options and share payouts on the 2014 convertible bonds. For longs who have sold their shares around the $2.50 level, they likely went straight into the hands of Liberty. For shorts who initiated or increased positions around the $2.50 level, they likely went straight into the hands of Liberty.

And why is this a problem?

First, it's because Liberty is keeping the shares. A short depends on their shares going into weak hands of investors who are chasing the tail end of a run. They are placing their bets that the shares they just sold will end up in a following sell off, increasing the momentum, magnitude, and duration of a bearish retrace. For a very large number of shares which have been sold over the last week or so, this just isn't going to happen.

Second, adding to the problem is the fact that sales by those who are or were long, either lightening their load or selling out completely thinking that $2.50 was a cap, have also sold to Liberty Media. Again, the shares are held aside and likely will not be sold any time soon. These longs or former longs now have cash, and will likely be eyeing Sirius XM for another entry point. As $2.50 holds, they may consider entering again at these levels.

And third, there is the expectation of share buybacks in the near future, either as part of a negotiated RMT between Sirius XM and Liberty Media, or through Liberty Media's actions after an RMT is performed. A buyback of $1 billion in stock, or more if Liberty wishes to leverage the balance sheet, could send share prices soaring with little hope for the shorts that the price will retrace so they can cover.

On top of all this, Sirius XM is having a banner year, blowing out street expectations and taking steps such as paying off debt, or refinancing at low rates. There's also the matter of $3 billion in NOLs that have recently been written onto the balance sheet, ensuring tax free profits for many years to come.

If I were short, I would cover, and do so immediately. If you're long, patience is a virtue while you wait for the impending short squeeze.

Source: Sirius XM: If You're Short, You Better Cover Sooner Rather Than Later