This risk, associated with a heavily shorted stock, could destroy your account!
As a day trader, you have many advantages against the long term investors. This is simply because you are not interested in the long term growth of an asset such as a company, index, or a commodity. You are interested in the short term situation of the asset.
We just discuss about it in this post.
As such, you can easily tell how the particular asset will perform in a few days’ time.
Difficulties of long term trading
In the 70s, Warren Buffet bought Coca-Cola shares. His was a long term bet that people will always buy coca-cola because of the moat the company had established. True to his prediction, the company is one of the largest in the world today, and he has made billions of dollars from it.
However, now coca-cola faces many challenges because of the health implications its products have on people.
20 years ago, Kodak was the largest imaging company in the world. Investors who had a 40 year prediction on the company has long failed as the company nears liquidation!
IBM was once the leader in computing. Today, the company is facing many challenges and its investors have lost billions.
These examples show that no one can tell the future of companies. The big Facebook and Google we see today might be a thing in the past years to come.
As a day trader, you can avoid these long term issues by looking at the short term details of an asset.
How to short a company
As a trader in equities, you can buy a company that is trading at a low price and sell it at a higher price in future. It is also possible to short a company.
In the past, this was rather a complex transaction to do because you had to enter into an agreement with another investor. Today, you can short a company at the comfort of your trading platform.
Assume company A is trading at $10 per share. After conducting some analysis, you forecast that the company’s real value is $5 per share, so you decide to short it.
In this, you go to a trader B who owns 1000 shares of the company. The real value of these shares is $10,000 (1000 shares X share price). You enter into an agreement with him where you borrow his shares and sell them.
In reality, if the shares of the company hits $15 a share, you will be in a negative because you will need to pay the investor, $15,000.
After borrowing the shares, you sell them for $10,000 and hold the money. If the shares goes down to $5 which you had predicted, you can now buy them back and return the 1000 shares to the investor. In reality, you will have made $5,000 in this transaction.
What happens after a Short squeeze?
As a trader, if you buy a company A for $10 per share, the maximum loss you can make is 100% loss of your money. This is because a company’s shares can never be a negative.
However, if you go short a company, the maximum loss you can make is infinity.
This is because a company’s shares can go up to any number. This is a serious problem that a certain trader made times ago by shorting a biotech company known as KaloBios.
After shorting the trade, the trader went for a meeting. After the meeting, he found that his account was $-300,000.
How to avoid it
To avoid a short squeeze, one is supposed to do a few things.
- You should avoid trading small caps. These companies are usually not very stable and continued investing in them will leave you to a lot of uncertainty.
- You should always have a stop loss. This stop loss will help you prevent massive losses like the trader above.
- You should keep an eye to your trade so that you can cover the losses. This is done by buying the asset back when it’s going up.