Unexplained share price rises: The role of short selling

Short selling: Profiting from falling prices

Short selling (or shorting) is a trading strategy where a trader sells shares they don’t own, intending to buy them back later at a lower price. Yes, this is possible! It works because brokers lend shares to traders, who then sell them on the market. However, this service comes at a cost—brokers charge fees for lending shares.

Can all shares be shorted?

No, not all stocks can be shorted. Some online broking platforms provide a list of shortable stocks, but availability is hit or miss. For shorting to be possible:

• The broker must allow short selling.
• The broker (or a lender) must own the shares.
• If you secure the shares for shorting, you can sell them immediately. Your profit depends on the stock price falling so you can buy the shares back at a lower price.

This is essentially the reverse of traditional (or “long”) trading, where traders buy low and sell high. Shorting just flips the order – selling high and buying low.

The impact of short selling on stock prices

Short sellers anticipate a stock’s price will drop. When many traders short a stock, it increases selling pressure, which can accelerate the decline.

But what if the stock price rises instead? Short traders typically have stop losses in place above their entry price. If the price hits this level, the short position is automatically closed by buying back the shares – this is known as short covering.

How short covering can cause price surges

Short covering creates buying volume, which can mislead other traders into thinking there’s a bullish trend. This buying momentum can trigger further buying, sometimes leading to a short squeeze – a situation where rising prices force more short sellers to close their positions, accelerating the stock’s rally.

How to spot a short squeeze

If you see a sudden and unexplained spike in a stock price, consider whether short covering is at play. Here are a few clues:

• No news or announcements: The stock is surging without any clear fundamental catalyst.
• Check if short selling is allowed: Not all stocks can be shorted, so verify whether short selling is permitted.
• Look at short interest data: Some platforms provide a “Short Interest” indicator, showing the percentage of shares currently shorted.
• Use a short squeeze indicator: Some trading platforms offer reports or indicators that highlight potential short squeezes.

Final thoughts: Proceed with caution

Short covering can create the illusion of a strong buying trend when, in reality, it’s just short sellers exiting their positions. If you’re considering trading a stock with an unexplained price surge, be cautious – especially if fundamentals don’t support the move.

One last word of warning: stock prices often rise gradually but fall rapidly. Shorting a stock is sometimes described as catching a falling knife – mistime your trade, and you could get cut.

Trade Radar can help by providing key market signals and data that enhance decision-making when identifying shorting opportunities.