The Mechanics of Short Squeezes

This post is part of our ongoing "Understanding VP" series. A glossary of VP terminology and links to other understanding pieces can be found on our portal.

“Shorting’s easy.  You short a stock, watch it double, cover in panic, then wait for the inevitable bankruptcy" – Anonymous Hedge Fund Manager from The Art of Short Selling

Introduction

This report delves into the dual dimensions of equity short squeeze risks: idiosyncratic and market, and introduces our unique "Breadth Squeeze" signals for identifying tactical buying opportunities.

Unpacking Idiosyncratic Short Squeeze Risks

Idiosyncratic risks are specific to individual stocks, influenced by short interest, free float, days-to-cover, cost of borrow, and event catalysts. Notable instances include the meme stock surges in AMC and Gamestop.

Our reports, such as "Surgical Stock Shorts: No Landing + Bullwhip Effect" offer insights into these opportunities.

Understanding Market Risks

Market risks are broader, often triggered by widespread forced selling or liquidation, as in scenarios where investors discard undervalued securities due to risk management strategies.

Our approach quantifies this "forced selling" to pinpoint tactical buying positions, synthesizing various equity breadth indicators into the comprehensive "Breadth Squeeze" signal. These different methods are all attempts to think from 1st principles.

VP Autocorrelation Signals

Our autocorrelation indicator, a 5-day rolling correlation between 1-week and 1-year returns across all members of an index, serves as a powerful short squeeze indicator. High values indicate significant price movements, signaling capitulatory selling and potential buy opportunities.

To avoid false positives, we add a condition that the 1y return must be significantly negative, aligning with the rationale behind redemption or margin call pressures.

Example from June 28th 2022 (link): "Our autocorrelation signals have triggered in both US and European equities: a powerful indicator of an ongoing short squeeze… Extremely high autocorrelation means that the stock that was down the most in the past year is also down the most in the past week and vice versa. This is usually a sign of total capitulation.”

The below charts show the very good historical performance of the autocorrelation signal. This is one of the strongest equity buy signals we have. This signal works best for broader indices with lots of constituents.

VP Thrust Signals: Proven Short Squeeze Indicators

The VP Thrust signal, one of our oldest, tracks the notional value of stocks moving up versus down. In extreme cases of forced liquidation, a significant notional fall in stocks relative to rising stocks often marks a tactical bottom. This indicator acts as a notional-weighted advance-decline line, triggering a buy signal at an extreme low.

VP Thrust signals are still performing well up to date.

VP Selling Exhaustion Signals: Anticipating Rallies

Our selling exhaustion concept focuses on the percentage of index members trading above their 50-day and 200-day moving averages. Spikes in this ratio signal imminent rallies, akin to a "golden cross" in standard technical analysis. Note, we are applying the concept to the percentage of index members rather than outright prices.

VP Selling exhaustion signals show a consistent track record, as shown below.

Finding and Interpreting Breadth Squeeze Signals

Breadth Squeeze signals are accessible through specific searches on our charts page. Triggered signals, like those for homebuilders, can be further analyzed with tactical charts to add conviction to the signal using this linked exact match search.

Clients can access VP short squeeze charts here.