Markit sheds light on ‘short squeeze’ phenomenon
Short sellers have done pretty well in uncovering underperforming stocks over last few years, but remain haunted by the spectre of ‘short squeezes’ and the potentially limitless losses incurred by a runaway short sale.
To ease these concerns, Markit has explored the factors that make stocks susceptible to squeeze to help investors identify likely candidates.
A short squeeze is generally defined as a situation in which shares see an abnormally large price movement, forcing short sellers to close out positions, often at a loss. Markit’s modelling found that shares which see heavy shorting activity ‘squeezed’ on just under 1% of trading days between January 2011 and March 2014.
A deeper dive into the phenomenon reveals that the shares which are most likely to squeeze are those which have a large proportion of out of the money short positions, says Markit research analyst Simon Colvin. “In addition, those with a large concentration of short sellers near their break-even point are more likely to see an unprofitable unwinding of their short base.”
But this ‘capital constraint’ theory only tells half the story, as the research found that short squeezes are also instigated by catalyst events such as positive news, earnings announcements and abnormal trading volumes.
“As a result, the group of the short targets which are the most susceptible to short squeezes, as defined by having a combination of capital constraint and catalyst events, are over 75% more likely to squeeze than the rest of the heavily shorted universe,” adds Colvin. “This group saw squeeze events during 1.67% of trading days between January 2011 and March 2014.”
This high propensity to squeeze has the potential to eat
into short sellers’ returns, according to Markit. In the last 12 months, the
short squeeze model has seen the shares most likely to squeeze outperform the
universe of heavily shorted US shares by 0.12% on an average daily
(open-to-close) basis.
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