Identifying stocks that are overvalued and betting that they’ll fall in price is one of the most extreme brands of value investing out there, and for short sellers that were active ahead of the the 2008 market crash it was also one of the most profitable. But while tireless research into overstretched stocks can produce sizeable returns when they collapse, getting it wrong or seeing the market turn against you can lead to a dreaded short squeeze. Despite being a byword for panic for canny individual investors a short squeeze can actually be a useful indicator of not only when to sell, but when to buy as well.  Let’s investigate.

What is a short squeeze anyway?

A short squeeze typically unfolds when a stock that’s being shorted by investors unexpectedly rises in price, rather than falls. After borrowing shares from a broker to then sell in the market, a rising price not only creates an instant paper loss but as other shorters scramble to buy back stock to cover their positions (either to stem losses or meet margin calls), the price can rocket.

At this point it hardly matters if the stock remains grossly overvalued or destined to eventually fall for as the squeeze tightens short sellers will feel the heat. Deciding to exit the trade then comes down to individual risk appetites, time horizons and financial clout.

What happens when the shorts get it wrong?

A good example of shorts getting burned occurred last year with supermarket delivery group Ocado. With it’s sole Waitrose contract, Ocado IPO’d in 2010 at a 180p flotation price that some analysts felt was a bit much even then. By March 2013 it was one of the most heavily shorted stocks in the market, with around 15% of its shares out on loan - a huge number. But that same month Ocado bagged a delivery deal with Morrisons that triggered a relentless rerating that saw its price rise by 200% through the year. The massive price hike was magnified by this big unwinding of short positions,  leaving just under 4% of Ocado’s stock on their books at the end of the run.

What tools are there to spot when the shorts may be shaken out?

Researchers who have studied the mechanics of short squeezes have suggested that it’s possible for short sellers to spot the warning signs early. Not only that, but a short…

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