Quant Concepts: Short Squeeze Strategy

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Brandon Strong: Welcome to Quant Concepts. During the earlier periods of the COVID-19 outbreak, retail investors experienced a trading phenomenon that has never been seen before. Stocks that were speculative in nature and were seen to be poor investments had triple-digit returns in a matter of weeks. The colossal return stemmed from a condition known as a short squeeze. A short squeeze accelerates a stock's price rise as short sellers bail out to cut their losses. For example, GameStop Corporation saw their shares go from US$4 in July of 2020 to US$325 in January of 2021, with no significant change in fundamentals.

So, today, we want to explore a strategy that can potentially capture the returns of an occurrence as the one we saw in 2020. This strategy is speculative and is only intended to highlight the fundamental and technical attributes of stocks during a short squeeze period.

Let's start by ranking our universe of around 2,000 stocks. So, in the ranking step, we are going to look at four different factors, which you can see here. And the first factor is short interest as a percentage of shares outstanding, which compares the shorted shares to all shares outstanding, and this factor is necessary as we want stocks with the highest short interest. Next, we have price change from one month ago or price change month-to-date which takes the latest price of the stock and compares it with the price of the stock ending one month ago. This factor will help capture the short-term price momentum that we are looking for in this strategy. Next, we have price relative to the 200-day moving average and price relative to the 150-day moving average. And just as we saw with the factor price change from one month ago, this factor aids in capturing momentum. However, this captures the periods of price appreciation for a five to seven-month period rather than a one-month period. 

Let's run through the screening process. So, as you can see here, we are only going to select stocks that are in the 70th percentile of our list, and most of the factors listed below are screening on short interest, as we want our stocks ready to be squeezed. Five of the seven factors have a screen of greater than or equal to 0, meaning that their price appreciation needs to be at least positive. And specifically, price change from 12 months ago is capped to less than 700% as we would be at a point where we would no longer want to be invested as it's likely that we are already at the highest percentage for that stock's appreciation, and we would most likely need to be out at this time anyways.

Next, I'd like to take a look at our sell rules. And we are going to remove stocks that fall below the 70th percentile of our list on the sell side. And as we saw with our buy rules, we want to exclude any stocks with negative price appreciation, so 0%, 0% and 0% here. Negative price momentum will prevent us from achieving the desired result of a short squeeze and that's why we included these screens on the sell side.

Now, let's take a look at our back test page. So, in our back test, we started the period from January 2007 and ran it until July 2022. And over that time period, we've seen significant outperformance in each timeframe. The turnover is quite high for our strategy. But this is acceptable for the short-term price momentum style we have created here. Additionally, the standard deviation and downside deviation of this strategy is extremely high. And this ultimately makes sense because we are tailoring the strategy to capture unfavored and highly speculative stocks.

So, if I go over to the portfolio section and I scroll down to the middle here, somewhere in between 2020 and 2021, we can see that some of the stocks that we picked up were GameStop Corporation, Plug Power, Qualcomm and AMC Theatres. And as we know, these stocks are very, very speculative in nature and had the price run-up during that period.

Now, going back to the summary page, looking at the alpha percentage section right here on the right, we can see the significant alpha generated over the testing period. So, significant alpha, excess return generated from these speculative names that we were holding during 2020 and 2021. The Sharpe Ratio is somewhat in line with the benchmark here. We can try to improve our risk-adjusted returns. However, this strategy is intended to hold a lot more risk.

I also like to take a look at the market capture ratios below. So, here, pretty interesting, but we can see that this strategy has a notable upside capture ratio of about 81% and a solid downside capture ratio, which is greater than 50%. However, this does not mean that this strategy will hold up on the long run. It's just something to take a look at and see how could I potentially capture some of these outrageous returns during a period of short squeeze.

Appreciate everyone for watching. Please make sure to check out the buy list accompanying the transcript of this video. Thank you all for watching.

From Morningstar, I'm Brandon Strong.

Find the buy list here.