Today, you’ll learn what happens when a stock is heavily shorted.
- Quick price recovery
- Price continues to fall
Heavily shorted stocks can recover quickly when short-sellers are having difficulty moving the stock price down. This happens because short-sellers cannot short stocks without an uptick due to short sale restrictions.
The restriction prevents the short-selling of stocks that are going down. It was made to prevent downward volatility.
In the past, downward volatility caused several flash crashes, so the rule was made to prevent short-sellers from crashing the market.
Sometimes, the short-sellers are overrun by the buyers who are constantly hitting on the Ask price.
Hitting the Ask price will result in an increase in the stock price, and short-sellers are forced to cover their short positions.
Short sellers cannot continue holding their short positions when the market is still rising.
Holding their positions in a rising market will increase their losses.
So, they try to cut their losses quickly resulting in an increase in the stock price.
What is a short sell?
According to Investopedia, short selling is done by borrowing a security and selling it to an open market and then buying the security at lower prices. (source)
When the security is bought back at lower prices, short-sellers make money.
To make money, traders need a tool to know when there are shorting opportunities.
Luckily, NASDAQ’s short interest tool is available for free. (source)
The tool lists the most viewed short interest which is certainly interesting to look at. From the list, selecting AMD stock will show more details.
The details show the historical data of short interest.
Quick price recovery
In the image above, the short interest of AMD stock is insignificant, unless, it is compared to some kind of a reference.
The reference can be anything, and it can be more about fundamental or technical analysis.
In technical analysis, short interest is usually compared to price action.
For example, when the price is at support and is also heavily shorted, a stock catalyst may come in and drive the price up.
Some examples of catalysts are good news, technical, fundamental, and other drivers.
Take a look at the chart of AMD, and see what happened.
AMD’s short interest was significant at the support, so its price quickly moved up around 17%, forcing short-sellers to cover their positions.
The support on October 30 was probably the catalyst for the move.
Now, traders should monitor catalysts, especially in heavily shorted stocks. These stocks may already be a trading opportunities.
For technicians, the opportunities are confirmed by using short interest information.
No wonder, short interest is used by most hedge funds.
Their decisions could be buying heavily shorted stocks at support levels.
Support levels are also considered key levels by retail traders because retail traders can also buy at support if the stock is heavily shorted.
Heavily shorted stocks can be a strong driver for buyers, and days to cover the short confirms it.
A higher number of days means that a stock has more sellers than buyers.
Most professional traders suggest that above seven days is safer, although the risk is still high.
In the video, he talks about short sale restrictions which mean short sellers can not hit the bid which causes the price to go up.
When at SSR, buyers can only buy at the Ask. The ask is always a higher price.
The price can consolidate especially when there are no catalysts.
Heavily shorted stocks are like falling knives, and catching them will hurt a lot of people.
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