Jim Woods

Blame It On a Short Squeeze

by Jim Woods   05/14/09

Free Trading Guides

I remember back in the late 1990s and early 2000s when investors were heavily shorting Internet stocks due to the fact that many of these firms had no earnings, no revenue, and in some cases not even a service or product.

Although many people made money shorting Internet stocks once the tech bubble burst, others who were ultimately correct about the unsustainable fundamentals of the sector, but who were just a bit too early with their shorts, lost a whole bunch of money.

The chief reason for these losses was the short-squeeze phenomenon.

How to Protect Yourself From the Short Squeeze

So, how do you avoid getting swept up in a short squeeze?

Well, that's the million-dollar question. Fortunately, sidestepping the short squeeze is easy when you use put options as your shorting vehicle. (See Short-Selling With Put Options 101.)

When you use put options to bet on a down market, you have already defined your risk. Sure, your put options could expire worthless, and you may lose your entire wager. And while this isn't a pleasant experience, it's far better than having to replace the shares you borrowed on margin from your broker.

I know I would rather take a hit on a put option than have to go into the open market and buy back a stock at a ridiculously high price on orders from my broker. (Plus, we can help you learn How to Pick the Right Put Option.)

As frustrating as getting caught on the wrong side of the trade can be, what's even more frustrating is getting that short-squeeze-induced margin call. With put options, you can avoid those dreaded margin calls while largely avoiding the negative effect on your portfolio from a short squeeze.

---

Jim Woods is a Senior Editor for OptionsZone.com. To learn more about him, read his bio here.