Options traders are acutely aware of the tremendous run in stocks we’ve witnessed over the past nine weeks. The virtually unabated move higher in the equity markets finally hit a roadblock this week, but for more than two months, the bull run has trampled many a short position.
Part of why we’ve seen stocks surge so high over these two-plus months is likely a phenomenon known as the “short squeeze.”
You’ve probably heard this term bandied about in the financial press whenever stocks go up inexplicably. Hey, if you don’t know why the market is moving higher, many experts just blame it on a short squeeze.
But just what is a short squeeze, and how does it drive stock prices higher?
A short squeeze happens when the price of a stock rises quickly, prompting shorts to run and “cover,” which simply means they must buy the stock in the open market to repay the shares they have borrowed on margin.
This flood of buying has the effect of generating higher prices, which in turn prompts more people to sell and take a profit. This action leads to brokers calling in more loans, which then forces many short sellers to go into the open market to cover their loans.
As OptionsZone shorting guru Michael Shulman says, “Short-squeezes can be ferocious, can last quite a while, and can be very expensive.”
As you might suspect, this cascade effect can give the most heavily shorted stocks some very strong upward momentum.
Sectors such as small caps, technology and particularly financials were some of the fastest-moving sectors over the past nine weeks. Not coincidentally, they were also some of the most heavily shorted sectors in March, according to data from research firm TrimTabs.
If you hold a lot of short positions, it can be extremely frustrating to get caught up in the buying flood that is a short squeeze.
I remember back in the late 1990s and early 2000s when investors were heavily shorting Internet stocks due to the fact that many of these firms had no earnings, no revenue, and in some cases not even a service or product.
Although many people made money shorting Internet stocks once the tech bubble burst, others who were ultimately correct about the unsustainable fundamentals of the sector, but who were just a bit too early with their shorts, lost a whole bunch of money.
The chief reason for these losses was the short-squeeze phenomenon.
How to Protect Yourself From the Short Squeeze
So, how do you avoid getting swept up in a short squeeze?
Well, that’s the million-dollar question. Fortunately, sidestepping the short squeeze is easy when you use put options as your shorting vehicle. (See Short-Selling With Put Options 101.)
When you use put options to bet on a down market, you have already defined your risk. Sure, your put options could expire worthless, and you may lose your entire wager. And while this isn’t a pleasant experience, it’s far better than having to replace the shares you borrowed on margin from your broker.
I know I would rather take a hit on a put option than have to go into the open market and buy back a stock at a ridiculously high price on orders from my broker. (Plus, we can help you learn How to Pick the Right Put Option.)
As frustrating as getting caught on the wrong side of the trade can be, what’s even more frustrating is getting that short-squeeze-induced margin call. With put options, you can avoid those dreaded margin calls while largely avoiding the negative effect on your portfolio from a short squeeze.
Jim Woods is a Senior Editor for OptionsZone.com. To learn more about him, read his bio here.