The Short Squeeze

The Smart Profits Report: Issue #157
Friday, November 5, 2004

The Short Squeeze: Don’t Get Squeezed When Investors Rush to Sell!
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The squeeze… it’s what shareholders and officers of many publicly traded companies dream about, sometimes in nightmares.

After I mentioned the short squeeze in the TravelZoo article recently, several readers e-mailed me to ask for more details. The questions weren’t about TravelZoo; they were about the squeeze thing.

What exactly, they wanted to know, is a short squeeze? How does it work? How do you use it?

Here goes: Companies that trade publicly have two components to their trading action, buying and selling. When you buy a share you are long. When you sell a share - that you don’t own - then you are short.

Usually, selling short is a bearish trade. And short sells can make you a lot of money quickly when a company’s stock tanks… But you’re also putting yourself at great risk, because you can lose MUCH more than your original investment.

Let me explain…

When Bad Stocks Soar, You Get Squeezed

You go short by selling shares into the market before you buy them, with the anticipation that you will be able to buy back the shares at a lower price to “cover” your position. The shares that you sold short were borrowed from another shareholder who was long. This is an internal transaction that the brokerage firm you use will handle for you. So, when you buy the stock to cover the shares, you are actually replacing the shares that you borrowed.

If the shares fall in price, you will make a profit because the shares that you bought back to replace the ones that you borrowed are cheaper. The difference in price is your profits. Just like buying stocks - or “going long” - you buy low and sell high, only you do it in reverse order. That’s if all goes according to plan and the share price drops.

If it doesn’t, and the price jumps up on you, the market may be setting up for a short squeeze.

Anatomy of a Short Squeeze

A short squeeze occurs when the price of the stock moves up sharply, which puts all the short sellers in a losing position, faced with the prospect of mounting losses. The more people who went short, the more severe the reaction will be.

In a panic, they all pile into the stock at the same time, trying to buy back the shares to cover their trades and get out of them. This buying demand and the lack of sellers drive up the price exponentially.

Is running into a short squeeze a great danger? Not really, and it’s one you never have to face even if you do want to go short.

First, a short squeeze will ONLY happen if you are dealing with stocks that have very small floats. The float refers to the number of shares that are trading in the public markets. While a company may have a lot of shares outstanding, a lot of those shares may be held by insiders or investors who are not interested in selling, thereby drying up the supply. And second, there’s a way around the whole problem - with options.

Short Squeezing Without the Unlimited Risk

The short squeeze is one of the most exciting “plays” in the market. But it can cause unlimited losses for short-sellers. In theory, a short squeeze could lose you many times what you have invested.

For example, let’s say you shorted 1,000 shares of TravelZoo at $5 - a price it has seen within the last year. When you shorted the shares you got $5,000, but you are still on the hook to replace those shares eventually. Today TravelZoo is at $86. If you had not covered until today, you would lose $81,000 on your $5,000 “investment.” OUCH!

The solution is simple: Buy put options, which give you the right BUT NOT THE OBLIGATION to sell shares of a stock. If the stock falls, you will make money on your put. If it doesn’t, your loss is limited to the cost of the put and not a penny more. I’ll show you with a hypothetical case… what would have been possible if TravelZoo had had options available.

Another Look at the TravelZoo Example

Let’s say a put on TravelZoo was outrageously expensive, 15% of the share price, or 75 cents a share when TravelZoo was at $5. A put contract for 1,000 shares would still cost you only $750 - and if you were wrong, as you would have been, that was the most you could have lost. Losing $750 is a lot smarter than losing $81,000!

Not many stocks go up as much as TravelZoo. It’s up more than 1,500% in the last year. And it keeps rising because of a massive short squeeze. TravelZoo certainly isn’t worth the $90 a share it commands now. It was questionable at $15 a share. No wonder everyone was so eager to short the stock. But they made a mistake you don’t have to. The solution is simple…

If there are no put options available, as was the case with TravelZoo until recently -STAY AWAY!

Good Trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Travelzoo was poised on the brink of disaster. It plunged $14 per share the other day, though it had soared to well over $70 before the big crash… I knew it would likely nosedive, I was powerless to act. Why? Because there were no bleeping options available. I could not buy a put if my life depended on it, find out more in Smart Profits #148, Travelzoo Stock: My Kingdom for an Option.

The Travelzoo conundrum does offer something: two ideas that are critical to profiting from options: Going with the market instead of emotions when timing your trades and applying good theoretical ideas like shorting TZOO with puts to another trade that could generate even more money, check out Smart Profits #146, Timing Your Trades: Two Ways to Expand Your Thinking And Your Profits.

Related Articles: