A short squeeze is a risk associated mainly with short selling on stock or indices and means that short sellers are forced to get out of the market (thus closing sell orders with buy orders), driving the price even higher. When shorting the stock market, there is an opportunity cost associated with this move, given that even if the stock goes down to zero, you’ll only make 100%. On the other hand, the upside potential is unlimited, since it can multiply by several times.
How to profit from a short squeeze situation
All the tips we’re about to share should be applied mainly for trading CFDs based on shares or indices. But before we get into that, we must talk briefly about the favorable market context. When a particular asset (stock or index) start to move lower, it could mean that some of the market participants are starting to trade reversals.
Usually a risk (financial, political, economic, etc.) arises and market participants start to sell on fear. However, if we look back over the past 50 years, even the largest market drops look like minor setbacks now.
It’s critical that you manage to stay objective and analyze the situation using concrete information (not fake news) in order to assess whether the weakness is short-lived or not.
Steps you need to take
Over time, you’ll manage to develop some skills that will help find situations like these, but until then, you should focus on following a few simple principles:
- Find situations where there’s a short-term weakness against long-term strength: the current situation in the US stock market is a very good example. From time to time, risk situations arise but the overall financial conditions (a.k.a. the central bank printing money) support the stock market to go higher.
- Wait until the market drops towards a key support area (previous high, moving average, Fibonacci retracement level, etc.). Here a good example of the Dow Jones Industrial Average that occurred recently:
As you can see the Dow started to drop once tensions with Iran started to build up. The index reached the 4h chart 200 simple moving average and then the short squeeze began, erasing all the losses and driving the price towards new record highs.
3. Don’t forget about risk management – make sure that you have a stop loss for each trade and always target a profit that’s at least twice bigger than the risk you take.
Short squeeze situations turn out to be a great opportunity to get long the stock market right after a retracement and could offer important trading opportunities over the long-term. Looking constantly at the charts you’ll find plenty of similar opportunities like the one we’ve shown.