Sometimes during a volatile stock market, especially after a series of dramatic down closings, you’ll see an equally dramatic rebound in key indexes.
This may last just one day before the market slips back to its slide, but it leaves some investors scratching their heads.
What may be happening is a short-seller squeeze.
Short sellers are traders who sell a stock they don’t own anticipating it is going to drop in price.
Stock Drops in Price
If the stock does drop in price, the short seller buy the stock back at the lower price and replace the borrowed shares.
The difference (less commissions, etc.) is their profit.
For example, if the trader believes stock X is going to drop she borrows the shares from her broker and sells them at the current market price of $50 per share.
When the stock does fall to $40 per share, the trader buys the shares on the market and replaces them with her broker, pocketing $10 per share profit (less commissions, etc.)
Stock Rises
If the short sellers have guessed wrong and the stock rises, they are then in a losing position.
Using our example above, instead of falling to $40 per share the stock rises to $60 per share.
Now, the trader must buy the shares at $60 to cover the shares she sold at $50 per share.
Our trader has lost $10 per share (plus commission, etc.). We hope she would have closed out her position before facing a $10 per share loss.
Stocks Unexpected
When short sellers bump into a market that does the unexpected, they may be looking at the same situation as our example.
If share prices rise unexpectedly, especially in a market that was looking like it should keep going down, short sellers may panic and close out their positions.
As short sellers begin buying to cover their shorts, it may push the market and other stocks up creating an even worse situation for the speculators.
Short selling is a risky game and not one you should play unless you know what you are doing. Never play it with money you can’t afford to lose.(By Ken Little)
