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LOCATION: INDEX >> GUIDE >> HOW TO SPOT AND PROFIT FROM SHORT SQUEEZES

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.

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