Trading the Short Squeeze

Trading the short squeeze – often the result of online retail traders battling the big hedge funds.  The squeeze occurs when the price action indicates a setup for a down move.  So how do you know that it fails early enough to get out of your trade and avoid being squeezed?

We analysis the price action on Tesla and Game Stop ( GME ) to see how you could have seen the short squeeze.

Here are some tips and tricks to keep you on the right side of the market.

 

A short squeeze has been a hot topic at the moment. The retail public is facing up with hedge funds resulting in some painful losses for the latter ones in the case of the GameStop stock recent volatility.

Is the short squeeze something new in the markets? It’s definitely not. Short squeezes and long squeezes have been around since long ago and will continue to happen. We can encounter both kinds of squeeze in various markets, including shares, futures, forex, etc.

The ability to recognize a possible squeeze is beneficial – not only you’ll have more chances to avoid getting trapped on the wrong side of the market, but you’d also be able to top up your trading setups arsenal. Keep reading to discover the tips on how to identify market squeezes.

Tesla Short Squeeze

The price action of the Tesla stock is an excellent example of a Short Squeeze. The short-sellers had plenty of opportunities to realize that they were wrong.

When the market stalls or seems to be overvalued, shorting can be very tempting, especially when the ego kicks in, similarly, when the market gets hammered, the urge to “buy low” may lure many unsuspecting traders into a squeeze trap.

Let’s break down what’s happened to help us not be among those who experience losses during a short squeeze. We’ll start off looking at the thirty minute timeframe and move on analyse the price action on the daily chart.

In the Tesla chart below, we see the powerful up-move in August that made a decent retracement in the first part of September.

The market formed a lower high, as you see in the circled area “1”. At that time, new sellers started to step in, considering that the company had bad fundamentals and the stock should sink. The market retraced down until around 360.0 (see the low “b”) and came up again, forming consequent tops 2,3,4 and 5 later on.

The first warning sign against shorting the stock comes from the major minor low – the market didn’t manage to drop below the low “a” but instead bounced up again, forming a higher low at “b”.

Notice that the minor highs 1 and 2 are still below the major high near 500. This would support the bears as they think that the market was merely offering them additional opportunities to “load up” on their shorts.

If we plot a trendline (see the grey cursive inclined line) based on the recent lows “a” and “b”, we can project the next “milestone” of the trend resolution as the market gets closer to the line. The price action around the trendline would tell us about the odds of the market is going in either direction. We don’t guess what may happen.  We make an assessment of the most likely move based on the price action we see and always react to what’s actually happening.

At the end of October, the market briefly broke down the trendline and made the low at “c”. The price them moved back up above the trendline, making the lower high “4”. Think of it in this way: if the market couldn’t break the previous higher low “b” and then could even get back to the price area of the highs 1, 2, and 3, where is the evidence of the market weakness? Such a “comeback” above the trendline is another good reason to turn away from shorting the stock.

Afterwards, the market formed lower high “5” and the higher low “d”. If you consider the stock’s price action in your decision making, such an environment should warn you. The gap-up after the high “5” is your final signal to abandon the idea of shorts, as sellers started aggressively capitulating, resulting in the major trend continuation.

When the market keeps breaking local highs and ramps higher, for sellers, it’s a clear signal that they’re likely wrong and might want to bail out.

Now let’s move to the daily chart to see the bigger picture of what was happening.

Arguably, there aren’t any reasons to short the stock considering the timeframe of the well-established long-term uptrend. After the market grew at the end of August and retraced below 350, it would be understandable to sell your long positions as the selling pressure appeared in September-November.

In order to be objectively bearish, we’d want to see the market breaking the key level (see the yellow dotted line), popping up, build a lower high and sell as the Market breaks down the lower high (see the blue arrow). In this way, we can get higher odds to be on the right side of the market.

If the market makes some lower minor highs while the recent higher lows are still in place, more often than not, it’s a bear trap. Even if you want to short the stock intraday, make sure you limit your risk using stop-losses or have a definite criterion of when you must cover your short position.

The short squeeze results from people getting on the wrong side of the market and not taking into account the price action. People can see the stock as overvalued or undervalued, but it’s the price action that proves who’s right and wrong.

In a stock like Tesla, it’s dangerous to go short when the prices keep breaking above the key levels making new highs, and you’d have an enormous risk to get your stop-loss activated and add fuel to the uptrend.

Game Stop (GME) Short Squeeze

Here is another example of the public madness around a Short Squeeze. While below is the thirty-minute chart; if we consider a big picture over a week or so before the stock tripled in price within a couple of days, there is no reason to short it.

From a technical standpoint, the stock is in a long-term uptrend, making new highs without any clear signs of the trend structure deterioration.

Some intraday short trades are possible, but these would be more advanced and short term trades. For example, on the 25th, the market topped with a vivid shooting star candle, as the move from 50.0 to 160.0 reversed heavily, forming a very long upper wick. An acceptable short setup would be selling when the shooting star candle’s low gets broken (see the red line “1”).

Another possible short setup is the shoulder formed between 90.0 and 100.0 (see the blue arrow). We would enter at the breakout of the shoulder’s boundary near 90.0 (the red line “2”).

If you attempted to short the market later on after another candle’s long upper wick, which tested 100.0, the market pushing above 100.0 should scream at you to get out of shorts.

The price action tells whether you’re right or wrong about your trading idea. In the case of GME, if you shorted the stock and the market breaks a significant high such as the wick that tested 100.0 (marked with the grey horizontal line), it should tell you that something is wrong and your idea isn’t working out.

The longer you remained stubborn and not admitting that you’re wrong, the more severe the loss would be.

The ultimate destruction of bears came when the market gapped up on the following day, and complete chaos started as both sides suffered from the erratic price action.

Hang Seng Short Squeeze

Hong Kong’s index is popular among day traders as the instrument consistently offers short-term trading opportunities. Let’s look at another short squeeze example that happened during the trading session in Hang Seng.

Numerous squeezes form even in a short-term timeframe daily. We’ll focus on the price action setup developed when the market was testing 28130, as you see in the thirty-minute chart below.

The market was declining for several days, starting a short-term downtrend around January 25th and showing some reversal signs at the beginning of February.

When you see a continuous series of lower highs and lower lows, you can conclude that the market is in a downtrend. Let’s plot a trendline through several lower highs (see the inclined line in the chart above).

More and more bulls join the trend and are pushing prices closer to the trendline, only to realize that they are on the wrong side of the market. The up-move cannot break the trendline or a previous high and declines in the downtrend’s direction. Buyers want to limit their losses, so they cover their long positions contributing to the next impulse down.

At the same time, bears open short positions taking advantage of the selling pressure caused by the buyers caught on the wrong side of the market, pushing the market even lower.

The cycle repeatedly continues until the market reaches the key level 28130, which was tested on the daily timeframe.

If you’re a short-seller and you’ve been accumulating your position during the downtrend, at some point, you will have to question where to cover your position. The exit area would most likely be around some strong price level, like 28130 in our example.

An Index as a financial instrument is designed to go up over time. So, if you’re a short seller, you’d be fighting a long-term uptrend, which is, in essence, a risky endeavour.

Suppose you’re holding a short position, the market goes down to 28130, powerfully bounces off the level and starts consolidating. For a trend to continue, we’d want to see similar price action to the previous waves. However, it didn’t happen that way. The following day, shortly after the opening (see the grey vertical line), the market broke the key level 28965 and kept pushing higher.

At this point, such a breakout of the key level is a strong signal for bears to cover or at least partially close their built-up short positions. In the thirty-minutes chart above, you can see how the numerous short sellers were capitulating and pushing the market almost until 29520, actively participating in the short squeeze.

According to our approach, after the squeeze, there wasn’t any objective technical setup to go short again, so the price just kept pushing higher, making more short-sellers close their positions, possibly reversing the preceding downtrend.

Conclusion

Short squeezes are nothing new as they continually happen in the markets due to the accumulated positions on the wrong side of the trend. Our job as traders is to recognize the squeezes with potential and take advantage of them.