Bear Squeeze

A bear squeeze is a change in market conditions which forces traders, attempting to profit from price declines, to buy back underlying assets at a higher price than they sold for when entering the trade. A bear squeeze can be an intentional event created by central banks or market makers. Other names for this condition include bear trap and short squeeze.

Most frequently, a bear squeeze is engineered by a central bank as they attempt to force up the price of a currency in the foreign exchange (FX) by limiting the availability of money on the market. However, this situation may happen in any market where the price of an asset is suddenly driven up. Bear traders holding short positions in the currency or other assets must buy at the current market price to cover their position, usually at a significant loss. 

Often a bear squeeze is associated with a short squeeze. A short squeeze is a situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and add to the upward pressure on the price. Market makers who can corner the market are likely to impose a bear squeeze.

As the term implies, traders get squeezed out of their positions at a loss. In the equity market, it is generally triggered by a positive development which suggests the stock may be turning around. Although the turnaround in the stock’s fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close them out even if it means taking a substantial loss.

If a stock starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if a stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price goes even higher.

Contrarians look for assets which have heavy short interest. Short interest is the number of shares which have been sold short but have not yet covered or closed out. Contrarians look for these assets specifically because of the chance of a short squeeze happening. These traders may accumulate long positions in the heavily shorted asset. 

The risk-reward payoff for a heavily shorted asset trading in the low single digits is favorable for contrarians with long positions. Their risk is limited to the price paid for it, while the profit potential is unlimited. This risk is opposed to the risk-reward profile of the short seller, who bears theoretically unlimited losses if the stock spikes higher on a short squeeze.

As an example, consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials. There is considerable skepticism among investors about whether this drug candidate will work, and as a result, 5 million Medico shares have sold short of its 25 million shares outstanding. Short interest on Medico is therefore 20%, and with daily trading volume averaging (ADTV) 1 million shares, the SIR is 5. The short interest ratio (SIR) means that it would take five days for short sellers to buy back all Medico shares that have been sold short.

Assume that because of the massive short interest, Medico had declined from $15 a few months ago to $5 shortly before the release of the clinical trial results. With the announcement of the results, they indicate that Medico’s drug candidate works better than expected. Medico’s shares will gap up on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions.