There are few trading situations that make even the most experienced market participants physically ill like being caught on the wrong side of a short squeeze. If you trade from the short side, it has most likely happened to you at one time or another, and will make you think twice about venturing back to the dark side anytime soon. There are some traders out there who specifically look for stocks with high short interest that look ripe (can be from an oversold or overbought condition) and look to start a squeeze.
I think it is safe to say that as many of our favorite high valuation stocks topped out earlier in the year, so did their short interest, as the parabolic price action caused shorts to panic, and new shorts to come in and try to pick “the” top, which results in the panic frenzy. But those longs who were happy to squeeze shorts on the way up may find it equally challenging on the way down after some stocks have been cut in half, as there may not be any incremental buyer for shares until value buyers finally find the shares intriguing. Meanwhile, most shorts will be out since they don’t wait for stocks to go to zero.
Take YELP for example. In yesterday’s Name That Trade Post post I highlighted the stock’s 50% peak to trough decline from early March to last week (chart below). The stock is obviously in a free-fall and the counter-trend rallies are anemic. Where are the shorts? Many have likely already covered, and even the 12% short interest in the month-old data might be overstating the case:
So the take-way here is that short interest readings can be a cruel mistress for short sellers on the way up, and long investors on the way down. Just as the panic to cover what could be unlimited losses can cause magnificent squeezes, the lack of those looking to make contrarian bets against a high flyer can take-away the buyer of last resort on the way down!