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Dear Reader,
Last week, while Neal and I were setting up a podcast to delve into the energy patch, our discussion naturally veered toward OPEC's Vienna meeting. Neal astutely pointed out that traders would likely rush to cover their short positions ahead of the oil cartel's announcement. So, we wasted no time in capitalizing on trader psychology and put on a call spread on the Energy Select SPDR Fund (XLE) in anticipation of traders getting ahead of OPEC's Sunday announcement.
In Flashpoint Trader, we made a strategic move by purchasing the XLE June 3, 2023 $77 call option set to expire on Friday and simultaneously selling the XLE June 3, 2023 $78 call option. Our primary objective was to collect the premium from the $78 call and look to ride a potential short squeeze in the oil market. With this trade, we positioned ourselves to profit if oil prices surged higher. As it turned out, the XLE did open higher on Friday, allowing us to take some quick profits when the market opened.
This move for oil, however, sparked a deeper curiosity in me about the intriguing concept of a short squeeze-a market phenomenon that can significantly alter market dynamics and offer big profit potential to folks paying attention.
So let's take a look at exactly what a short squeeze entails and how we can harness its power for profit...
The Anatomy of a Squeeze
To better understand a short squeeze, let's first look at the concept of shorting. This means betting on the price of a stock to go down. To do this, the short-seller borrows shares from a bank or other big holder and sells them, hoping to buy them back at a lower price later. They then return the shares and keep the difference in price as their profit.
When traders borrow shares and sell them at a lower price, it leads to the accumulation of short positions. This phenomenon is known as short interest, which indicates the percentage of outstanding shares that have been sold short.
But what if the price of a stock with high short interest suddenly goes up, not down? All the traders who bet against the stock are in trouble. They have to buy back the shares quickly to minimize their losses.
This rush to buy back shares is what we call a "short squeeze". With so many people needing to buy shares all at once, demand for the stock goes through the roof. But because so many shares were borrowed for shorting, there aren't many available in the open market. This pushes the price up even more, causing a chain reaction. Short sellers are forced to buy at increasingly higher prices, which sends the stock even higher.
Think back to GameStop Corp. (GME) in 2020 for a real-life example. During the height of the pandemic, GameStop was struggling and became a favorite target for short sellers. But a group of everyday investors on social media decided to fight back. They boug…
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About the Author
Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.