How To Play The Short Squeeze And When To Cash Out

Includes: LULU, NFLX, TSLA
by: Adam Betancourt

In an article I wrote yesterday (Tesla's Short Squeeze is Here), I addressed a potential short squeeze in Tesla Motors, Inc. (TSLA). As explained, a short squeeze can provide investors with a tremendous opportunity to bank profits, if traded properly.

Short Squeeze: Explained

Heavily shorted equities (or currency pairs) provide investors with an interesting and lucrative opportunity to make a brisk profit- a potential short squeeze. A short squeeze can occur when a company that has a high proportion of short interest compared to overall float sees a bump in share price. In essence, short interest refers to the ratio of available shares that are being shorted in the marketplace. Keep in mind however, having a high short interest should serve as a signal that something may be fundamentally wrong with the underlying business. Think of the short ratio as a gauge on bearish sentiment in the marketplace. On the other hand, if the stock gains a bit of upward momentum, the potential for acceleration is massive.

When the value of a heavily shorted stock begins to increase, the short positions lose money - the most fundamental concept behind shorting shares. In order to cover a short position, an investor must purchase shares in the marketplace. While this generally will not affect the price of a share, stocks with a substantial short interest may become flooded with these share purchases if a significant upside move occurs. Given the risks involved with shorting a stock, these investors generally monitor their positions closely to avoid catastrophic losses. So, when the price begins to rise, these short positions trigger stop losses, which in-turn close out the position buy purchasing a long position in the stock. These formerly short investors then become long investors, pushing the stock even further, and causing even more short positions to close.

Example: Netflix

Take Netflix, Inc. (NFLX) for example: On April 15th, Netflix had a short ratio of 16.5%. For a large-cap corporation, this is a significant proportion of shorts. Ahead of earnings, shorts piled in to take advantage of the expectedly dismal report on April 22nd. While the street expected $0.19 in EPS, Netflix posted earnings significantly higher at $0.31, sending shares soaring in after hours trading. Here's where the squeeze occurs. The surprise earnings beat triggered a somewhat substantial gain of roughly 7%. Now, 7% seems reasonable for a company that posted an unexpectedly great quarter. However, this spike then transformed into an overnight gain of 23%. How? The original spike in share price "squeezed" the shorts out of their positions in exponential numbers. The "snowball affect" of shorts closing their positions and new long positions entering the scene in an attempt to cash in on the pop continued to push the share value higher.

How to Spot a Potential Short Squeeze

When combing through the stock market in an attempt to find opportunities to play a short squeeze, there are a few things to keep an eye out for. The first of which is a large short % of float. These figures can be found on most major financial websites, but a good place to look is (Nasdaq). The higher the short interest, the greater the potential for price appreciation.

Next, check the average daily volume. Get a feel for the amount of shares traded on a normal day and try to find some benchmarks for "above average" volume in the stock you have selected. The short interest divided by the daily volume will give you another interesting way to look at this information (the amount of days it would take to cover all short positions, based on daily volume). A higher value for days-to-cover signifies a possibly longer, more drawn out squeeze.

Finally, make sure the share price has an upward trend and a bullish catalyst. For example, Tesla has recently made a run up to an all-time high level of roughly $55. However, this wasn't a quick move, rather it seems to be in a price channel leading up to current levels. Also, Tesla has a short interest of 43%. Here, the bullish catalyst is the potentially (and most likely) positive earnings report on May 8th.

Once the pieces fall in order, and you have created a long position, ride it out and look for signs of a slowdown or a pullback.

When to Ring the Register

Keep a close watch on the chart. You are looking for the same trends you were when you spotted the potential squeeze- just opposite. Volume will, without doubt, spike during the run-up due to the flood of short covering. As you can see in the chart below (Data Source: Yahoo! Finance), on April 22nd, volume shot up to nearly 400%. This is the short squeeze in action. From there however, it leveled off just as the share price stabilized. This is a great sign that the squeeze is coming to an end.

(Click to enlarge)

Some squeezes, such as the aforementioned Netflix squeeze, take place in a matter of hours or days. Some take a little longer to develop. I believe that Tesla will slowly drag the shorts into long positions however, based on the days-to-cover metric being so high.

Also, for those more drawn out short squeezes, continue to watch the short interest levels. As the shorts leave the stock, the number should decrease. Make a determination regarding what the "normal" short interest of that stock should be and stick to it.

Food for Thought

Another name that I potentially see a short squeeze scenario developing is Lululemon (LULU). With roughly 26 million shares short, and the sting of quality issues in its products diminishing, I feel that there is a potential squeeze in the near future. Look into it.

Disclosure: I am long TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.