It’s 9:39PM on a post Fed minutes Wednesday, and the SP500 market is printing record all time highs.

After a 45 point (1.89%) Trump dump trade, we have erased all the deficit and found our way higher despite geopolitical risk.

Many traders will start to wonder, is this a good level for me to buy now that the index has “broken out”?

The answer is NO – not this time, because this smells more like a good ol-fashioned short squeeze then a bull market.

I want to explain to you what is happening at the moment in the market, but first I need to explain a few concepts for those that may not be familiar.  If you want the final goods, scroll lower. :)

What is a Short Squeeze

When a trader short sells a security, their intention is to later buy it at a cheaper price and keep the difference as a profit. Only problem is, it has to drop in order for a profit to be materialized.

Once a trader is short, if they wish to exit the position they have to buy back the security. If the price is running higher, they are chasing it on the way up as their losses increase.  This is what we called a short squeeze.

It sounds painful, because it is.  Shorts are literally getting squeezed out of their positions and taking a crystallized loss.

How Can You Tell it is Indeed a Short Squeeze?

The difference between a buyer who wants to purchase stock and one who is doing it to exit a short trade is that the first person wants to actually own it.  The second is just closing a bad trade.

It is important to recognize that markets actually move to the level where the most amount of traders will lose the most amount of money.  This is what I call the move to desperation.

So how can you tell if the market is going up on a short squeeze or if we got real buying interest?

Volume!

Imagine that prices break above a previous high, obviously there will be short sellers getting out of their trades by buying.  But if there are NO actual motivated buyers, volume will be low and weak.

On the other hand, if there are both buyers and shorts getting squeezed, volume will be really high!

Now that you are a short squeeze prophet, here is the daily chart for the SP500 market – what’s your call?

short squeeze

 

What is Open Interest

In options trading, open interest are the number of contracts that have been formed between buyers and sellers.  Keeping it simple, for every buyer there is a seller, and when the two agree on price a new “contract is formed”.  From here, losses and profits are passed one from party to the other for the life of the contract.

The number of these contracts that exist are called open interest.

Who Sells Call Options?

If you think the market is going to stay at this level, slightly higher or lower – you can sell call options and make an income known as premium.  So why doesn’t everyone do it if most conditions will make you money?

Because the losses are unlimited to the upside, and the times you lose, you tend to lose a lot more if you do not have the discipline to manage your risk.  Depending on the product and the options, you may not even have control of how much that loss is if the product moves higher and you are short the calls.

So while a lot of people will tout he selling of calls as an income strategy that works 90% of the time, be careful you do not become the person that gets blown out the 10% of the time.  You will lose less frequently, but it can be a lot more than you gain, even though you gain it more often.  If that makes sense to you, you’re ahead of the curve.

Where is The Current Call Option Open Interest?

The June 16th options expiry shows 97,500 call options for the SP500 index at 2,400.  There are 66.8k call contracts at 2,450, and over 200k below 2,400!

These numbers may make you think? So what?

Well, because there are a lot of call contracts in existence (open interest), there are short sellers of these call options.  These short sellers are short below the current level, and a lot of them are now losing big money as we cross above the all time high level at 2,400.

What are desperate short sellers?

Buyers chasing price higher looking to close their pain.

 

short squeeze

 

Why Does a Call Option Short Squeeze Cause a Market Rally?

To get the point in a simple fashion, when you are short call options you can either buy them back to close out your trade at a loss, or you can buy the asset on which the options are written to “hedge” your position and stop future losses.  Why is that? Because buying the index offsets any further losses from the short call option (short call loses, but index gains an equal amount).

This means buyers are getting long the SP500 futures in the after hours session and driving the price higher on low volume, as no willing buyers are getting in who actually want to own the futures.

This short squeeze panic buying causes more option sellers to get nervous, fueling even more buying of futures, which fuels more upside in price and more short call option to start getting nervous.

Because of this, by the time it is all said and done, markets can move a lot higher a lot quicker than you think, until they squeeze every last drop of the short sellers and stick them with losses.

Why?

Because the market moves to the area that will cause the most financial loss for the most amount of traders.

There you have it, now you know how to find a short squeeze using options open interest.  You have the makings of a TRADEPRO.

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