Bloody Short Squeeze Example

Sep 8, 2007: 4:10 AM CST

Folks, trading is NOT an easy game, especially if you are trying to predict the market and follow what seems natural to you.

For those of you who are following the news regarding the “housing crunch” and “credit crisis” that has plagued the market recently, how many times have you heard about the dismal state of various housing stocks?

Might it be a great idea to try your hand at shorting them for the first time? I mean, if the situation is that pathetic, isn’t it a sure-fire win if you just throw a dart and go short?

In theory, yes. In practice, absolutely not.

You cannot watch a TV show, get an idea, execute the idea, and then make wild profits. I’m sorry, but it does not work that way. Try it yourself if you don’t yet believe me.

Sophisticated trading requires a variety of skills, foremost is independent research and analysis on your own part. Yes, you can use TV shows in conjunction with your analysis, but I highly discourage acting solely on what you here on the TV, no matter how reputable the source or information.

Case in point, housing stocks and the general housing industry has been declining quite rapidly, violently, and steadily – traders have managed to make a great deal of money ‘going short’ these stocks. I hope you have been fortunate to reap some profits short.

However easy it may seem, you cannot just “go short” and hope for the best. Let’s look at a chart and see for yourself:

From the beginning of the chart display until now, price has fallen from $29 to $15 – a 50% drop. But all has not been well for the shorts at all times.

After price broke the $25 barrier (early June, 2007), short-sellers have endured two short squeezes, one of which could have literally wiped out entire trading accounts that were overleveraged.

Let’s look closer.

In early August, price shot from $17 to $24 in three days for little reason other than to shake out speculators and squeeze those who were short. You can see from the volume leading up to this day that a larger amount of volume was taking place, indicating that – it is assumed – many traders were establishing new short positions while other were betting this was the ‘bottom’ of the decline, thus buying positions.

It didn’t take much for price to begin to soar and ‘take out’ the overhead stops, especially when price breached the 20 period moving average, a key zone where most stops were placed (according to technical analysis parameters).

The day that price broke the 20 period MA, a massive short squeeze took place catapulting price upwards following a gap – price shot from $21 to $24 which was a significant move away from the recent daily range of less than $1.

The violence of this price move was not likely caused by ‘panic buyers’ who can’t wait to establish a position, but from panic short-sellers buying in to cover their (sometimes massive) short positions.

People tend to panic OUT of positions and not INTO them. You’d do best to remember that when you see large volatility moves on a price chart.

After price catapulted to this level, breaking even the declining 50 period moving average and sluicing through more ‘short covering’ stops… what did price do?

It fell disgustingly down in a four day decline from almost $23 down to near $17 – cutting the traders both ways (those that bought to cover their short positions… and those who bought shares to establish a long position, betting on the ‘bottom’ of the market).

Those who were short were RIGHT in their bias and in the OVERALL price movement, but few traders (especially short-term traders who live by relatively tight stops above key support or resistance levels) held through this massive volatility short squeeze – and they should NOT have. They should have honored their stops and exited according to plan.

Nevertheless, this is yet another example of how your opinion – or bias or belief – on the direction of a stock can be absolutely perfect… but you can walk away with a massive loss in your position because of the forces outside of your control that essentially prey upon the ‘masses’ and weaker traders.

It’s not enough to be “right” in the market, but to profit from your bias, which often means taking actions or measures that might not be intuitive to you initially.

Whatever you take from this lesson, realize that you must approach the market with humility and sophistication – especially if you are a discretionary trader. Trade with a plan and utilize proper stop-loss placement and do not second-guess a well-tested strategy or plan.

And as always, be safe and don’t trade beyond your means.

You never know when the next sure thing will lure you like a Siren Song into buying before a massive decline (only to reverse) or short-selling before a massive Short Squeeze (only to reverse as well).

Be careful!

Comments Off on Bloody Short Squeeze Example

Comments are closed.