How to Avoid a Short Squeeze
Selling a stock short is a technique that allows traders to profit from a stock's decline. A short squeeze is a technical term that describes a sharp rise in the price of a heavily shorted stock that forces shorts to cover their positions at whatever prices they can get, often at a substantial loss. The most effective way to avoid a short squeeze is to not get into one, which requires knowing the signs of a potential short squeeze and avoiding stocks and situations where one is likely.
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Instructions
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Check a stock's float -- the number of shares outstanding that are in the hands of investors and are available for trading. The smaller the float, the more likely a short squeeze.
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Consult a stock's chart. The most appropriate time to short a stock is at the beginning of a major decline. A stock that has been going down for a while attracts more shorts but the chances of a short squeeze increase as the price gets lower and the stock's weakness becomes more apparent.
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Consider a stock's "short interest." "Short interest" is the percentage of float sold short. Stocks sold short must be bought back at some point. If too much stock sells short, it may be difficult to find shares to buy to cover a short position, which is why short squeezes often occur in heavily shorted stocks.
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Review a stock's daily trading volume and "days to cover." The lower the daily trading volume, the harder it is for shorts to find enough shares to buy at current prices and the easier it is for a short squeeze to develop. "Days to cover" estimates how long it would take the shorts to cover their positions. The more "days to cover," the greater the possibility and ramifications of a short squeeze.
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Tips & Warnings
Use stock message boards as a secondary indicator. A heavily shorted stock will have a message board where shorts -- stock bashers -- are rampant with predictions and rumors designed to scare others into selling their shares. By itself, such posts mean little but combined with the above factors may indicate whether a stock is ripe for a short squeeze because the shorts are either too desperate or too careless.
An effective way to avoid a short squeeze is to short highly liquid mid- to large-cap stocks.
You can't avoid a short squeeze if a company whose stock you are short is bought out -- the stock price will spike to the amount offered, which is usually much higher than the closing price of the day before, leaving you no choice but to cover at a loss.
