Short Covering Rally Pushes Market into Overdrive

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Alex Partida

Oct 13th 2022  .  3 min read

Short Squeeze Overcomes Big Drop

The stock market trended upward this morning into the Consumer Price Index (CPI) report at 8:30 a.m. Eastern. When CPI numbers were released, all indexes quickly plummeted. Data revealed that core inflation has lowered since the previous month’s report yet still came in higher than expected. Wall Street expected the numbers to be at 8.1%, and when they came in at 8.2%, the market fell rapidly.

Market sets up a trap

When the opening bell for the cash session sounded, buying pressure quickly flooded the market. Continuous buying volume arrived at the psychological level of 3,500 in the S&P 500 futures (/ES), ultimately launching the market back up.

Big players on Wall Street are often two steps ahead of retail traders, and today was another display of a bear trap for retail traders. The information released this morning may not have been good, but it could have already been priced into the market

It only took the first thirty minutes to cover short positions before squeezing out the remaining shorts. A short squeeze is a common trap that leads to a massive rally like today. Short squeezes occur when there is an overwhelming imbalance between the shorts and longs in the market. Big players in Wall Street tend to hide this trap behind bad news to catch any last-minute chasing positions.

The short squeeze

A few variables fueling the short squeeze are greed, bias, and the fear of missing out (FOMO). When bad news comes out, and retail traders see the reaction, more times than not, the fear of missing out leads to an excessive flow volume to one side of the market. In today’s example, the CPI report sent the market tumbling causing FOMO to the downside. Greed also plays a part in the trap as traders start to watch their profit and wonder how much they can get out of a trade, but before you know it, the position quickly reverses

The explosion of a short squeeze happens when the perfect mix of profit-taking and hedging takes place together. When a significant-sized fund has long-term short positions and the market starts to rally, they hedge their work by taking the opposite side of the trade in the short term. Mixing the lack of selling pressure and hedging is the perfect recipe for an extreme rally.

After a day like today, it is essential to zoom out and look at the bigger picture. In the macro, the stock market sentiment is still bearish. Short-term price action should not be mistaken for a macro sentiment shift.

To end the week, the psychological level of 3,700 on /ES is back in play. This level should be used as the line in the sand moving forward. Some targets above 3,700 are the 21-day exponential moving average at 3,740 and the psychological level of 3,750. 

On the downside, if the market remains below 3,700, there is the point of control (POC) level at 3,670 and another psychological level at 3,650.

Market rips back to end day positive

The Nasdaq and the S&P 500 fought back positive to close the session. The S&P 500 futures closed up 2.52%, gaining 90.25 points, while the Nasdaq futures closed up 2.05%, a gain of 221 points. The Dow followed, closing up 2.94%, adding 857 points.

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