A short squeeze is a commonly misunderstood investing phenomenon where a heavily shorted stock rallies very quickly and then retraces. They can be difficult to predict, but they do happen from time to time and can be dramatic. There are common characteristics of short-squeezes that can be useful for forecasting purposes but we have to be careful about how those events are used to create a forecast.
How likely a stock is experiencing a short squeeze can be evaluated by two measures.
The Short Float
The short float is the percentage of shares floating in the market that are currently sold short. It’s normal for any stock to have a certain amount of its stock held short, but sometimes this portion can become very large. Imagine a stock that has half its floating shares held short. If the company reports an unexpected profit or partnership, buyers may step in to start accumulating the stock which would create a loss for the shorts. As the stock starts to rise, those short traders have to buy back their shares to close their losing position, which could continue to put pressure on the stock to the upside. That is one way that a short-squeeze can occur.
Short Ratio
The short ratio is the number of days it would take to close all outstanding short positions if all of the average volume was used for just that purpose. A thinly traded stock with a small short float could still suffer a short squeeze if there isn’t enough volume in the stock to allow short traders to close their position without raising the price. This is another version of a short-squeeze.
In October 2008, Volkswagen became the most valuable company in the world because of a short-squeeze. Porsche surprised the market by announcing they had acquired 74% of the company’s shares. The purchase had dramatically reduced the float, and because they weren’t going to sell, it increased the short ratio.
Volkswagen stock had moved from $56.20 per share at the beginning of September to $232.30 by the close on October 27, 2008. That squeeze made the company more valuable than ExxonMobil (XOM) at the time.
Volkswagen’s stock did that because the shorts were leveraged (as they usually are) and had to unwind their trades at any price to stop the losses. Shorts were buying the stock back, which kept driving the price higher and higher. This is a good example because the stock subsequently did what most squeezes do and dropped significantly after the initial rally.
A Current Squeeze
This brings us to the topic today of Joy Global (JOY), a mining equipment manufacturing and servicing firm. From a fundamental perspective, JOY’s performance has been degrading and the stock has been struggling to break its 2012/2013 highs. Like many companies in this situation, bears have moved in and currently hold 22% of its floating shares short.
For a large S&P 500 component, this is actually a significant short float and the short ratio (currently just over 15 days) is also climbing to an all-time high. Traders are assuming that JOY’s stock price is likely to fall as economic growth in major manufacturing economies like India and China slow. That isn’t an unreasonable forecast, however, the company surprised investors with an above-expectations earnings report on June 5, 2014 that created a brief short-squeeze.
The stock rallied from $58 to just over $64 per share as investors responded to the data that was better than expected and yet still much, much worse than the same quarter the year before. Besides a high short float and ratio, a squeeze can also be identified by an immediate retracement from the highs following an announcement.
As you can see in the next chart, JOY immediately dropped from $64 to $60 per share, bounced briefly higher, hit trendline resistance, and is now dropping again. For short term traders, we think this presents an attractive technical opportunity. The top of the recent gap at $60 could act as support, but if the gap is filled, we would expect prices to drop back to February’s lows as the lucky long-traders continue to take profits and reallocate their positions.
Joy Global (JOY): Chart Courtesy of eSignal
Stocks that experience short-squeezes aren’t necessarily bad firms that will go out of business, but they are rarely a bullish signal. Often a short-squeeze triggers what you should think of as a bullish capitulation. This is the point that the bears are forced to do something about their losses (by buying back their shorts) and it is actually a strong contrarian signal. This is a technical play that doesn’t have much to do with the fundamentals, except to the extent that the price trend in the stock doesn’t match eroding margins.
As the S&P 500 gets a little “toppy,” we think evaluating a few bearish positions makes sense. However, this is still technically a bull-market so traders should be prudent about risk control and positions sizing so they don’t get caught on the wrong side of a short-squeeze themselves. Now that earnings have passed, this may be the perfect opportunity for a long put position in JOYG rather than an outright short.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.
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