On Wall Street, short selling (borrowing shares to bet against a company) is one of the most challenging endeavors to master. First, from a long-term perspective, anyone shorting is hypothetically swimming upstream. Why? Because U.S. markets tend to march higher over the long term. Image Source: Zacks Investment Research Pictured: Over time, stocks go up. ( Second, even in down markets, short-covering rallies can be vicious. For example, in April 2022, after the initial downside break, the Nasdaq 100 ETF ( QQQ Quick Quote QQQ - Free Report) ) rallied 10% in just two weeks before cracking wide open. In other words, ill-timed short sellers would have been blown out of their positions. Image Source: Zacks Investment Research Pictured: Shorting is easier in theory than practice. Finally, investors theoretically face unlimited risk in short selling whereas unleveraged long positions face no more than 100% downside. Short Squeeze Mania ( 2022 was a rare year where short sellers won. Former high-flying names such as those in the ARK Innovation ETF ( ARKK Quick Quote ARKK - Free Report) ) got hammered as sellers came after high-valuation growth stocks. However, markets act in a cyclical manner. As the market finds a bottom, beaten-down stocks stretch to the downside, and late short sellers pile in, short squeeze opportunities develop. ( In late 2021, Carvana ( CVNA Quick Quote CVNA - Free Report) ) traded as high as $376 per share. However, as car sales slowed, the eCommerce company’s economics declined, and Carvana swung to a wide loss. Image Source: Zacks Investment Research By late 2022 shares were trading as low as $3.55, down 98% from its highs. Image Source: Zacks Investment Research Nonetheless, the online auto-retailer provided a perfect example of a short squeeze phenomenon on Thursday. The beaten-down stock price, a short interest north of 50% of the stock’s float, and positive news fueled the fire. Thursday, the company surprised Wall Street by divulging that it expects to swing to a profit of $50 million. The unexpected news sent shorts running for the hills and the stock higher by 56% on the session. Image Source: Zacks Investment Research A Domino Effect ( Ever since the Reddit forum “Wall Street Bets” sent shares of GameStop ( GME Quick Quote GME - Free Report) ( ) into the stratosphere in 2020, one lesson investors have learned is that a few times a year, when market speculation runs high short squeezes spread like wildfire. For example, in 2020, the GME speculation spread to stocks like Virgin Galactic ( SPCE Quick Quote SPCE - Free Report) ( ), AMC Entertainment ( AMC Quick Quote AMC - Free Report) ( ), and Palantir ( PLTR Quick Quote PLTR - Free Report) ( ). The CVNA squeeze spread to other beaten-down and heavily shorted names like Beyond Meat ( BYND Quick Quote BYND - Free Report) ) Thursday. Catching a Short Squeeze The secret sauce for catching a short squeeze is to look for: · Heavily beaten-down names crossing over the 200-day moving average. · Highly shorted names (20% or more of the float should be short) · Ensure that you’re in a speculative market (major indices and high-flying stocks are in play) It’s a Matter of When, Not If, the Music Will Stop Because of the inherent volatility and overnight gap risk associated with heavily shorted stocks, short squeeze plays should be traded with minimal size or not at all. History teaches us that when the “trash floats to the top” like it is now, it is typically short-lived and ends badly. In other words, if you’re going to trade highly shorted names sell some into strength and date them, don’t marry them. A swath of short squeezes can be a sign that the market is becoming frothy and danger (or at least digestion) is ahead. For example, Virgin Galactic shot from $14 to $57 in two months, just before the tech space began to break down. Image Source: Zacks Investment Research Takeaway Thursday saw a swath of short squeezes in the market. Investors who want to participate in trading heavily shorted stocks should consider the implications ahead of time. Regardless, short squeezes can signify short-term frothiness in equities markets.