|Some Further Reading on Short Squeezes||The 3 Steps to Scanning for a Short Squeeze|
What happens to a stock’s price after a short squeeze? Well, nearly every short squeeze in history has followed the same exact trends so it’s pretty predictable what will happen to the share price. You can even make money off this repeatable trend!
After a stock experiences, a short squeeze the stock’s price will follow a 3 part trend. First, immediately after the short squeeze the stocks daily volume and price will begin to plummet. Second, after a couple of weeks of decreasing volume, the implied volatility will also start to decrease on the stock as well which stabilizes the price. Third, after implied volatility returns back to normal the stock will then finally fall in price back down to its normal level.
It is important that people fully understand how to make money from a short squeeze. There are opportunities to make 200-300% if you know what you are doing. I do not recommend people get into these plays without knowing first what they are doing. However, if you know how to play options and short a stock while hedging then you will be able to make considerable returns.
Let’s jump right it then. Here is an entire article going over what happens to a stock’s price after a short squeeze.
The Theory Behind the Short Squeeze Lead-up Phase
In order to understand how a stock’s price reacts after a short squeeze we first need to discuss the lead-up phase to a short squeeze. This is because you need to know what the stock’s price is before it completely goes crazy.
In theory, all capital markets in the world follow the efficient market hypothesis. This is a theory that states that investors and markets seek to buy investments that they believe are wrongly priced. As the investment moves to its true price, the investor will make money. This is generally how investing works.
However, this efficient market hypothesis fails when you factor in the psychology and behavior side of retail investors. A 2003 study published by Princeton University demonstrated that this efficient market hypothesis fails when you consider mass retail investors.
This is important to understand because once retail investors begin to leave a stock after a short squeeze the efficient market theory will begin to take back over. This is the basis for how professional investors and hedge funds make their money from the declining stock price after a short squeeze.
Now that we understand the theory behind what happens to a stock’s price after a short squeeze let’s look at the 3 part trend.
First Phase of a Stocks Price After a Short Squeeze
There are 3 trends that happen to a stock’s price immediately after a short squeeze. This is the first phase where the stock’s price will plummet from its high price.
The first trend for a stock’s price after a short squeeze is dramatically falling volume. This fall in volume will cause the stock to begin to move back to its true price value. This is important because during a short squeeze what keeps the stock rising in price are retail investors forcing short sellers to buy back their positions.
As the retail investors stop buying the stock the volume will decrease. Once this volume starts to decrease then the stock will start to plummet in price as everybody begins to sell their positions. When this happens you will see the stock begin to fall back to its normal price levels.
As we can see from the above image of the GameStop short squeeze that happened in January 2021 right after the short squeeze the price fell back to a ‘normal’ price. This was because of this first trend of short squeezes affecting the stock price.
Simply put, immediately after a short squeeze a stock’s price will begin to fall. This fall in price is because of a decrease in volume and retail traders buying the stock. This is the first phase of the stock’s price after a short squeeze.
Second Phase of a Stocks Price After a Short Squeeze
Immediately after the short squeezes stock price has fallen there is a second trend. This trend is where the price will consolidate and it can last for several months as the market recovers.
This second trend of a stock’s price ‘recovering’ after a short squeeze is the stabilization phase. In this phase, the stock’s implied volatility will begin to slowly drop over time. Implied volatility is how volatile or explosive the stock can be in the eyes of the market. Implied Volatility is just a calculation of the stock’s range, volume, and price history over the past 30 days. Think of this as a computer’s best guess on how fast a stock can move.
During this second trend of a stock’s price after a short squeeze, the stock will consolidate in price and implied volatility. People will stop trading the stock and instead investors will start to come back. This is when the chances of another short squeeze begin to go away.
The stock’s price will also begin to have less of a range as the price and volatility begins to consolidate. You can see this in the above image as GME’s price range went from $80-$40 down to $60-$50. While the price might have consolidated the stock is not at the end of the short squeeze lifecycle. There is still one stage left.
The Third Phase of a Stocks Price After a Short Squeeze
This is the final phase of a stock’s price after a short squeeze. During this trend/stage you will see the stock’s price begin to fall back to its price and volume before the squeeze took place.
This is often called the ‘bag holding’ stage as people who bought into the stock during the second phase will be left holding the bags of those who sold out. In this 3rd and final phase, the stocks price and volume will begin to fall back down to the levels it was at before the short squeeze took place.
The first thing to fall will be the volume on a stock. This is because fewer and fewer people are trading the stock. Instead, retail traders go looking for the next short squeeze in the market. With this decline in volume, the price will being to fall as well.
The reason the price falls in relation to a decline in volume is because of the efficient market theory we talked about earlier. The stock market seeks to price stocks at their true value. This means that the artificial pump of a short squeeze will eventually fall back down to a normal level.
In theory this third and final phase of a stock’s price after a short squeeze, the stock will drop down in price to where it was at before the squeeze even happened. However, depending on the hype surrounding the short squeeze this slow decrease in price might happen for a couple of years or even a decade!
Can You Make Money From The Stock After A Short Squeeze?
So now that we know what happens to a stock’s price after a short squeeze the question remains “can you make money from the stock’s falling price?”
The answer is yes! So long as a trend is observable and predictable you can build out an investing model to make money from it. However, we need to be careful as the market can move against us at a moment’s notice. I would only trade one of these positions if I was confident that retail investors would leave the stock.
The best way you can invest/trade a stock after a short squeeze is by buying a volatility crash play. Since we know that volatility will decrease once investors start leaving a stock we can position an investment to profit from this. The easiest way to do this is to sell a covered call on the stock once it starts dropping.
Never sell a naked call or put. This is a recipe for disaster and should always be avoided.
If you sell the covered call your downside is limited as well as your upside. However, if the stock starts to go down and the volatility decreases then you will end up making money on the call. If you sold a GME-covered call during the first phase after the short squeeze then you would have made around 30-40% within a couple of weeks as the volatility crashed.
After this once the stock reached phase 2 of the after-short squeeze life cycle on a stock you can sell Iron Condors to make money from the decreasing volatility even further. Had you done this you would have easily made another 15% on the investment.
Finally, in the third phase of the lifecycle you can simply short the stock with a hedge. At this point, retail traders have left the stock and the volatility has decreased back down to normal levels. The only thing left is to sell the stock short and then wait as the market returns the stock to a normal value.
That is how I invest and trade stock after short squeezes. When done properly you can make a decent return with a small amount of risk. However, you need to understand the risks in these kinds of trades. If the stock’s volatility starts to trend upward then you should consider exciting your positions.
There you have it; everything you will ever need to know about what happens to a stock’s price after a short squeeze takes place.
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