Short Squeezes and Danger

Oct 3, 2007: 2:42 AM CST

Some say that “going short” is more dangerous than being long – I’m open to debate the question, but I do like to point out charts of interest that show interesting situations that warrant further attention.

Such is the case in Pulte Homes. We hear on the news just how horrible, unprecedented, catastrophic the housing market is and how it will never recover (I’m exaggerating). It’s enough to make you want to call up your broker and have him short thousands of shares of falling home builder stocks, isn’t it?

Not so fast, noble traders. It’s not that it’s a “Fade the News” situation, but more of a “the pubic is [almost] always wrong” situation. It seems easy:

Watch a news story, think about it, act on it logically.

Unfortunately, the market rarely rewards those who approach it with such little understanding or patience – at least not in the short-term. Yes, if you had been short any major housing stock, or even the housing ETF, you would have made double digit profits. But don’t you still need to look at the chart and plan your entries alongside carefully placed stops?

Of course you do.

What happens when you watch a story on TV and then try to act reactively to it?

In this example, we have news that unsold home inventory has fallen to a new low. Why not short a random homebuilder… Pulte Homes?

Here are headlines from Yahoo! Finance on October 2nd:

“Wall Street Down on Home Sales Figures”

Main Idea Quote: “In economic news the National Association of Realtors said its pending home sales index in August fell 6.5 per cent to 85.5, a record low. The index has fallen 21.5 per cent in the last 12 months and has lost 16.5 per cent in the past two months.”

“U.S. Home Sales Send Major Indexes Into The Red” (Forbes Magazine Online)

“Let’s see just how far Pulte Homes fell today. I bet it fell 5% or more….”

Wait – why did the stock go UP today?!

It’s understandable to be confused when “things like this” happen, but realize it’s just part of the “market game” we all play.

Short Squeezes trap those who are short, and usually people (weak hands especially) who are short are a lot more reactive in terms of covering a position at the slightest hint of danger (in the form of rising prices). This is because short selling is by nature done on margin, and losses are (theoretically, though 99.9% unlikely) unlimited.

A short squeeze is like a cascade effect where price begins to rise, causing some shorts to cover, which usually attracts early buyers (trying to catch the absolute bottom), which causes more shorts to cover, which then causes a rapidly escalating situation of traders scrambling to buy stock to cover their positions. We know it is a short squeeze when price falls back down just as fast as it rose (or faster).

Anyway, what differentiates a “short squeeze” from a normal reaction is the rapidity with which it occurs, (usually) the volume spike, and the immense (relative) price bar range in relation to previous bars.

By the way, I would advise not to get tempted to rush into to buy Pulte Homes yet… if you’re desperate to own it, at least wait until it forms a proper bottom (with at least a retest of previous lows) and/or breaks solidly and convincingly above the 50 period moving average (which appears to have acted as key resistance lately).

As always, it comes down to looking at the overall structure, digging a bit deeper than “Uh, price should go down,” and keeping protective stops in case you get suckered by seeming price ‘games’ played by the professionals.

Be careful and try to have fun!

.

4 Comments

4 Responses to “Short Squeezes and Danger”

  1. jkw Says:

    Have you looked into single stock futures? They seem to be a much better method for shorting stocks, in part because the margin requirements are lower (allowing you to withstand a short squeeze better) and you don’t have to be able to borrow the stock. If short sellers start primarily trading SSFs, short squeezes might go away.

  2. Corey Rosenbloom Says:

    I’ve done a bit of research into the single stock futures, but never went anywhere with it. I mainly stick to the index ETFs to play out my short-term biases in the market – I often don’t do outright swing trades on stocks anymore. I’m finding it’s easier for me to keep up with the indexes and analyze them intensely for trading. I just like pointing out certain patterns or educational lessons in stocks when I see them.

    I actually haven’t done much – in terms of thinking about short squeezes and reduced margin – with the SS Futures but I will begin to toss that into the mix as well.

    Remember how I posted that I’m getting more into futures? Your comment helps solidify that sentiment. Futures are the way to go, it seems!

    Thanks!

  3. Aaron Says:

    Corey,

    This is a very interesting post. I completely agree with you when you said that it is easy to dismiss the gain on bad news as something that happens once in a while, but it certainly does happen more than most people think. The homebuilders are the very best example you could possibly use. Nice site, I’ll keep checking in.

  4. Corey Rosenbloom Says:

    Aaron,

    Thank you for the comment and for reading. Not only have I seen it happen, I’ve been on the wrong side of the trade probably dozens of times in my life. It’s just so tempting – especially when you’re just beginning – to hear something that makes sense on TV and then rush out and take the logical position. It wasn’t everytime (because I profited as expected on some), but more times than I thought possible, I would lose small amounts of money thanks to tight stops, or large amounts of money (especially early on) because I couldn’t believe (literally) that price was going against me. You learn from times like those.

    The housing stocks will probably continue to go lower, and they may do so with force. But they probably won’t do it on days when the media sounds the death knell for that sector or the general housing market.

    It’s just part of the game that keeps us coming back… provided we don’t lose too much money on these trades.