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Short squeezes and why they matter for the market

Updated: Jan 13, 2023

We've seen a lot of intense short squeezes over the last week, many of which seem to be coming to a rather unceremonious end.

What is a short squeeze?

When there's a high concentration of bets against a stocks price rising in the form of shares sold short, it can lead to what's called a 'short squeeze'. The dynamics of this are as follows:

  • Usually the stock has a relatively small float (50M or less)

  • Often there's 25%+ or more of the float sold short

  • Shares become hard to borrow at multiple brokers and clearinghouses

  • A catalyst begins a frenzy of buying, whether it's news-driven, a viral social media phenomenon (think Reddit or Twitter), or something else like blowout earnings

  • This leads to buyers piling into shares (and often near-dated close to the money calls as well)

  • As prices rise, shorts get squeezed out because they are borrowing to sell short, and margins get compressed

  • This causes a disorderly exit, often with traders smacking the offer, leading price to go higher and higher

The delta squeeze element

When short squeezes are powered by a frenzy of near-dated close to the money call buying in such size that volume exceeds open interest we often see dealers hedging their delta aggressively, buying shares in size commensurate with the exposure they have.

An example would be ABC company has $10 calls with a 33 delta. That means that for every $10 call contract someone buys, the dealer is going to be looking to hedge that delta with about 33 shares bought long. That way if the call gets into the money, the dealer isn't sitting on a loss.

So when we see a huge amount of call buying this impact of implied leverage through call buying can create a bit of a feedback loop:

  • Buyers pile in to these near-dated close to the money calls

  • Volume exceeds OI

  • Dealers hedge aggressively

  • Prices rise significantly

  • Shorts start to get squeezed out, creating further upward price pressure

How do short squeezes end?

Most squeezes end just as quickly as they began, sometimes even more rapidly. Because often is the case that these companies are highly shorted for good reason (broken business models, unprofitable, loaded with debt, defunct management, etc).

When a squeeze end is ending there's often signs, especially if it is options-driven (as many are these days):

  • Call premium flows dry up in the near-dated close to the money contracts

  • We then see options holders start to sell aggressively, driving premiums much lower

  • Dealers begin to sell shares bought for delta hedging, leading to share prices collapsing

  • Late entrants panic out, sending premiums even lower, and leading to more dealers selling shares, driving prices even lower

  • This all leads to a sudden supply of unwanted shares without the commensurate amount of buying to absorb it

Why does this matter?

The last week of short squeezes created a lot of interesting market footprints, to include a number of low quality unprofitable companies with high short concentrations being among the best performers. The last time this happened was March of 2022. Before that November and also February of 2021.

Noticing a pattern? That's because they marked short-term tops in the market. These sorts of buying panics are, in a sense, parts of the market 'crashing upward'. It's not the type of price action or order flow we want to see if we're bullish, because it demonstrates irrational euphoria, and often happens during time where there was just strong bullish breadth, imbalanced CBOE equity put/call ratios to the call side, and highly unusual options activity focused in these highly shorted equities.

While this is all happening, a lot of funds that have concentrated shorts in these parts of the market are having to flatten their books, particularly on the short side. What may be construed as a bearish capitulation. When bears exit such positions in size, it leaves plenty of room for sellers to come back in, whether they're trapped longs exiting at a more favorable price, or other opportunistic shorts.

Zooming out to the bigger picture, however, these events are also a sign of a market that is ready to take a meaningful breather. Whether this time is different remains to be seen, but I am erring on the side of caution as the current countertrend rally appears to be on thin ice. Of course CPI tomorrow and the 10-year auction that follows will be key to determine risk appetite, particularly in these longer duration unprofitable and highly shorted stocks.

1 commentaire

Great post. Cheers.

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