Trade Review: The Short Squeeze

01/11/2012 8:00 am EST

Focus: STOCKS

Jeff White

Founder, TheStockBandit.com

A classic “short squeeze” occurred recently in Weight Watchers International (WTW), and this case study emphasizes the importance of risk management and how quickly a short position can go awry.

You may have heard the term “short squeeze” but may not understand what traders mean when they say it.

I recently found a good example of exactly what happens when a short squeeze occurs. It starts simply enough, with a stock in a downtrend. As the downtrend becomes more obvious and continues day after day, more and more traders jump in…and that’s where the problems begin.

Weight Watchers International, Inc. (WTW) was in a clear downtrend. The stock had failed in early November to clear late-October resistance, and it subsequently reversed lower. Each bounce was sold since then, with a series of lower highs and lower lows.

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Last week, the stock broke to a new correction low by undercutting the December lows on heavy volume. What followed, however, was obviously both shocking and painful for the shorts.

Wednesday’s arrival delivered upbeat news for Weight Watchers, as US News & World Report put it at the top of the list for best weight loss diets in 2012. Consequently, Wednesday’s bar was a bullish engulfing bar and Tuesday’s low was undercut before a close above Tuesday’s high on even heavier volume and a 7% pop. 

Then we saw near-record volume on Thursday and an 8% advance, and further upside continuation on Friday and a near-9% gain.

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Change of character? Absolutely. Value buyers stepping in to accumulate a good company that is undervalued? Hardly. 

This is the portrait of a short squeeze, and it’s one reason shorts require absolute stop losses. The sudden shift can rip the faces off of shorts who panic and rush for the exits while opportunistic bulls get long. The combination can be explosive, as seen here in WTW.

The lesson? Watch your shorts and don’t give them more leeway than they deserve. Keep stops in place and be mindful of what’s possible when the tide shifts. This is one kind of move you don’t ever want to experience from the wrong side of the trade!

By Jeff White, trader and blogger, The Stock Bandit

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