HOW TO AVOID GETTING SQUEEZED TO DEATH

Being forced to buy back stock that you went short on during a violent and sharp rally is what many refer to as a short squeeze, and something that no trader wants to endure very long. It is akin to being a seven-year-old kid again and having your big Uncle Willie give you one of his really tight hugs and not let go.

That general feeling of helplessness is what traders who are short feel, as their stock begins to rise without pulling back.

Short squeezes happen regularly and are a fact of life. When you become free-thinking enough and willing enough to make profits while others remain stuck in the same old limiting investment methodology, that’s when you will truly begin to maximize your potential income.

One of the most violent situations for a short squeeze hap-pens when a down move is anticipated after the market has sold off on some pejorative news and closes on its lows and appears to be very weak. A number of hedge funds and retail traders pile on the shorts and carry the positions overnight. Many who do not, are looking for weakness the next morning. When the next day comes around, if the market manages to hold on its gains and not break down, weak shorts will begin to cover their positions on the failure of the follow-through or breakdown. This can also happen on an intraday basis, possibly following a poignant news announcement, like the Federal Reserve cutting 50 basis points

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6, you can clearly ascertain which formations are classic forma-tions. But, obviously, trends reverse. At times these particularly bearish looking formations don’t follow through. A double top, for example, which doesn’t head lower but in fact breaks out to new highs is a classic case of short sellers helping push a stock higher.

As I have said many times to students and other traders, having a trade that doesn’t work out shouldn’t be shameful, unless, of course, you fail to manage the risk behind it. If you cannot manage the risk or if you overleverage yourself, it can trap you. It will do so especially when a market that appears to be going straight down changes direction and swings into a huge, short-covering rally, while you do nothing but begin forming ulcers.

When you are able to switch your hat and recognize these situations, it can be a profitable disposition. You become part of the problem for the shorts and help add fuel to the fire by join-ing in with the buyers and bejoin-ing the squeezer instead of the squeezee.

If you enter a trade in which a bona fide short pattern does not follow through to the downside, as expected, it can cause a wave of buying by the people who originally initiated the short positions. When these shorts want to get out, the short squeeze can be a powerful process. To spot these situations takes time and experience. But having that ability can help you in these sit-uations. If you are short yet can realize what is going on, you can turn a bad situation into a profitable war story.

It’s true that you would have lost some money on the trade by getting stopped out of it, but if you cut your losses quickly, then you will not feel emotionally or financially battered

fol-must be prepared to walk away from many small losses along the way.

Short squeezes can also happen if the stock you are borrowing from your broker needs to be returned before you would like. The need to return the stock causes an increase in demand for the stock. This increase in demand can create a very frenetic situation.

Look for a couple of fundamental things when you are shorting a stock; spotting these developments may also help pre-vent you from being squeezed as well. Many stocks that go on parabolic runs do so because traders feel the stock is overvalued and decide to short it, despite the fact that there is no viable technical setup for the trade. When the stock pulls back, most of the traders will cover their position in order to get even in the trade. I advise you to be extra judicious when shorting stocks with greater than a 20 percent short interest and a relatively low float. This combination can be a lethal one to those who like to short stocks, as these stocks can be more easily manipulated.

Short interest numbers are updated monthly and can be found on most financial Web sites.

A parabolic rise is shown in Chart 6.12, which involves Genesis Micro (GNSS). As shown in the chart, the rise begins to pull back and looks like it might be showing some mercy to the short sellers.

However, what appears to be a great shorting opportunity turned out not to be so great. This type of situation needs to be considered a normal occurrence in your mind if you are to ever become a successful trader. Learn to live with trades not going as you planned, because having trades not work out is part of life as a trader, whether you are shorting or going long. Stocks do move up as well as down. Many trades, which appear to be good shorts and are well calculated, may not work out. However, it does no good either, to make 19 out of 20 trades right and end up with a net gain of zero, just because of one trade in which you neglected your stop-loss and which ran against you big time.

What I am about to say next is so important, it overshad-ows all other trading errors by far and is the biggest reason in which traders fail. If I repeated these words on every page of this book, I would not be overstating their importance:

Never fail to manage risk.

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CHART 6.12 Using trailing stops is important, as market reversals can quickly change a winning trade into a losing trade without the proper position management.

If you are like the average trader, just following those sim-ple words alone could potentially save you a lot of money and great emotional grief over the course of only five years. Think about it. Be patient when you are shorting stocks and always stick to your stop-losses. The market goes through gyrations to the upside and the downside. So, keep in mind that creating solid price targets, executing the plan, and managing risk is the key to making real money.

SUMMARY

Short selling is an integral part of most professional traders’ arsenals. The ability to profit in both up and down mar-kets should help enhance your overall returns and will provide you with more opportunities when looking for trades in the mar-ket. This chapter discussed some common characteristics found in most stocks which head into a downward trend. Being cog-nizant of one-day reversals, exhaustion gap-ups which can sig-nal an end to a rally, as well as picking good spots based on Fibonacci price levels to short a market should help you better time your short entries, or at the very least, provide a good spot to exit out of a long position. Traders who short also need to be aware of the potential for a short squeeze and how to avoid get-ting trapped.

Overall, traders who are looking to profit consistently must be willing to trade from both sides of the market.

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PHASE II

From Marksman