How
To Spot And Profit From Short Squeezes
by
Russell Sands
I
make a lot of mistakes, but I think that one of my strengths
is that I don't make the same mistake twice. Well, at least
not twice in a row. The markets are changing all the time. On
the other hand, the more things change, the more they stay the
same. This makes technical analysis valid. Historical patterns
tend to repeat themselves, albeit with slight variations. This
can also be the double edged sword of technical analysis. You
can't rigidly follow something without stopping to think about
what's going on. But if you do see a pattern or a `signal',
and you analyze the whole situation to see that nothing else
has changed, then maybe you're on to something. I don't know
whether this qualifies as technical system trading or judgmental
decision making. And quite honestly, I don't care to make the
differentiation. My approach to the markets is to integrate
the two, relying on patterns that I know have positive expectation,
tempering the trades with judgment and common sense, and using
all my experience to make a decision. Last month I was pleased
to find a trade that I had to `reason out', and my reasoning
turned out to be correct. However, I also made a sloppy mistake
in my execution, and left a lot on the table. This month, I
got another chance.
I
never used to trade Natural Gas because the market was too thin.
It was only when somebody asked me at one of the seminars did
I bother to notice that the open interest was about ten times
larger than two years ago when I last looked at it. Now I don't
really know if the opposite of Natural Gas is Unnatural Gas,
or if it's Unleaded Gas, or some other kind of Gas. My friends
tell me that Natural Gas is not very well correlated with the
rest of the Energy complex, but I don't know if that means it's
negatively correlated (as in complementary) or just plain uncorrelated.
But what I do know is that there are certain things that can
make a market (any market) just look `funny'. I don't know whether
to call this technical or intuitive, and it's even sometimes
hard to describe because it can often look different, but it's
the kind of thing that when you see it, you know it. One of
the funniest things that can occur in a market, funny meaning
strange, as opposed to humorous, is a short squeeze. A short
squeeze occurred in the March Natural Gas contract. I thought
I saw it coming and I turned out to be right, but I entered
an order to the desk without stopping to think about something
first, and it cost me a lot of money. Luckily, the pattern repeated
itself in April, and this time I got the whole thing.
First
of all, in order to have a potential for a short squeeze, the
market has to be in an uptrend. Gas made a breakout to the upside
at about 160.00 two months ago, and had been moving nicely ever
since. Also, the uptrend must continue in such a way that traders
who got short at an inopportune place never really had a chance
to get out without taking a loss. This can be characterized
on the chart by a series of higher daily highs as well as higher
daily lows. The thought should be that regardless of when you
sold this market, the trade almost immediately went against
you, and it has been getting a little worse continuously every
day since then. You keep thinking, one nice sell-off and I'll
get out, but it never happens, and your loss just keeps growing.
If this happens to enough people, then at some point they all
must throw in the towel, and that's when the market really explodes
to the upside.
The
second thing you need for a short squeeze is what we call a
`forced timeframe'. In other words, even if you were short and
losing money, and decided to be stubborn and just hold on forever
(even if it meant getting wiped out), you couldn't have that
option if you wanted to. This happens to locals all the time
on a short term basis. If a local is stuck in a trade and it
keeps going against him all day, then somewhere in the last
half hour of the day, he is just going to puke that trade out,
because a local almost by definition is a short term trader
who does not usually carry overnight positions. For the position
trader, this scenario occurs when a contract month is about
to go off the board (expire). It's like the game clock is about
to run out, and you have nowhere left to go, you must cover
the trade or risk physical delivery.
This
leads to the next criteria for a short squeeze, namely that
the lead month (the one about to expire) is significantly outperforming
the back months on the charts, i.e., the spread is widening.
You can see this by looking at a spread chart, the difference
in price between one month and the next. First of all, the fact
that the lead month is outperforming the back months tells you
(fundamentally) that there is a shortage of immediate supplies,
and the market must rally even further. Even though we are technicians,
the markets are ultimately controlled by the economics of supply
and demand. This is simply an example of using technical information
to impute the fundamental situation. Furthermore, the fact that
the lead month and back months have different chart patterns
means that technical traders are less inclined to simply roll
forward whatever position they may have, leading to an increased
likelihood of some liquidations.
Finally,
all the above criteria should repeat themselves on an intraday
chart on the last two or three days before expiration. If you
watch the price action closely, you can almost `see' the panic
and desperation of the shorts; they're losing money, running
out of time, and have nowhere to go. You can also watch price
action, even on a tick by tick basis, to see which direction
is the path of least resistance. If the market can rally 100
points in five minutes, then take an hour to retrace half that
move, then rally strongly again in a short period of time, this
is a market that has a lot of underlying strength. Also, if
you see more upticks than downticks in any given time period,
this is another indication of the direction in which the market
would like to move.
If
you can put all these things together, you have set up the possibility
of a short squeeze. Of course, nothing is ever definite, but
the reward on these trades is worth the minimal risk when you're
wrong. Your strategy should be to buy as much of this market
as you can reasonably tolerate according to your money management
system, and then hold on as long as possible, planning to liquidate
with a market-on-close (M.O.C.) order at the very end of the
last day of trading. You are hoping for a final burst and that
the market will close right on its highs. I saw all of this
in the March Natural Gas contract on the next to last day of
trading, which was around Feb. 18th. I bought the market, and
then put in an M.O.C. order the next day (2/19). The market
started rallying about a half hour before the close, and I was
feeling pretty pleased with myself. The next thing I know, the
phone rings and my broker is giving me a fill on my Gas M.O.C.
order. The market rallied 700 points
in the last fifteen minutes, and closed at 193.00. Unfortunately,
I got filled at 187.00, leaving $600 per contract on the table.
What happened? On the last day of trading before a contract
expires in the N.Y. Energy pits, the `closing range' is taken
to be the last forty five minutes of trading, in order to allow
enough time for everyone who wants to square their positions
to do so. And an M.O.C. order can be filled any time within
that forty five minutes. So the broker, who didn't want to wait
until the end of the day when things might get hectic, decided
to fill my order in plenty of time, unfortunately for me.
Well,
I was really pissed, but I learned something new about order
execution, so I just chalked it up as the price of tuition.
I also made a mental note to be more careful the next time.
I didn't really expect it to happen again so quickly, but when
the same scenario presented itself in April Gas the following
month, I was ready. This time, I came in long and bought more
on the next to last day. On the morning of the final trading
day, the order desk at my brokerage firm called me up to verify
my position, and remind me that I had to be out by the end of
the day. When they asked if I wanted to place any liquidating
M.O.C. orders, I told them no, that I would call the orders
in right before the close. They warned me to give them at least
a half hour notice, to which I replied that I would give them
orders ten minutes before the close, that should certainly be
sufficient time for them to get a market order into the pit.
This time, I was right on the money. The market was strong all
day, but in the last forty minutes of trading it really started
to explode, going from 500 points higher on the day to 1400
higher right at the end. And I got out of all my position, five
minutes before the close, within 100 points of the high.
Even
though it was too late to take advantage of it, even the Wall
Street Journal got wise to what was happening in the market.
But, so far even better than 1993, this time around the trade
rolled itself over to the following month (February), and we
are still in the trade with hopefully more profit potential
left to come. Of course, if the weather remains cold and volatility
remains high, I would not try to do anything fancy at the end
of the month, just grab your lightning rod and hold on for dear
life.