The Liquidity Trap: A Short Seller’s 3-day Nightmare | TradingSim
Sep 23, 2021
Written by: John McDowell
In the sordid world of low float, lower-priced stocks, a lot of what goes on often defies typical volume and price logic. Often, you’ll see trading firms and high-net-worth traders going head to head in a battle for control of these highly volatile stocks. Retailers, too, like to jump in the mix and get their piece of the pie. It’s like a feeding frenzy of sharks when these stocks go. Yet after the melee, when the feeding frenzy is over, there often remains a strategy lurking just a few days later called the liquidity trap.
Table of Contents
What is a Liquidity Trap?
Most fickle traders move on for the next big trade, quickly forgetting even the ticker they traded the prior day. But for veteran day trader and purveyor of InvestorsUnderground.com, Nate Michaud, the excitement is just getting started.
Traders like Nate continue circling the prey from the day before, watching for any signs of life.
In his Sunday Scan and other free material, Nate describes it as a liquidity event that creates a problem for heavy-handed short sellers to cover inconspicuously.
Volume Drop Off
Think about it this way. Stock XYZ trades 70 million shares on a momentum day — way above average for its normal volume. News is wonky, maybe it’s earnings, perhaps it’s just a press release to pump momentum into the stock for the very purpose of selling it back down.
Here’s what one of these days might look like:
While this creates a fantastic intraday long and then short on the backside, it can put overnight short sellers on thin ice the next day because the volume falls off. You might only see 700,000 shares traded the very next day. Now imagine a handful of short sellers holding a million shares. That isn’t going to be easy to cover without shoving the price back up.
Days to Cover
There is some possibility that the days to cover from the day of heightened trading activity may affect the need to cover. If unfamiliar with the concept, here is the formula:
Days to Cover = Current Short Interest ÷Average Daily Share Volume
It is essentially a formula to determine how long it would take shorts to cover without really affecting the price of the stock.
The difficult thing to determine is the current short interest on such short notice (no pun intended). This information isn’t readily available and only updated bi-monthly. However, by putting two and two together, one could discern that a heavy amount of shorts entered the stock on the day of the momentum gap. If the volume then falls back to average levels, the Days to Cover could have increased significantly.
However, a lot of this will depend on the size of the float and the amount of volume traded.
Here is a visual example showing $OCGN short interest at around 49 million shares:
At the time of this post, there are 193 million shares available in the float for OCGN. It has an average 3-month daily volume of around 16 million. Given this information, it would take around 3-6 days for shorts to cover all their shares.
The implication that this has for liquidity traps is that it will take large short sellers quite a few days to offload their short positions. Their ideal situation would be a slow steady fade lower over a longer time frame.
Where things get interesting are on day 2, 3, or 4.
If the price of the stock begins to rise again on lower volume, it gets closer and closer to the average price of the short sellers’ positions. In other words, the water gets hotter and hotter beneath them.
As astute traders take note of the price action, they begin to smell blood in the water once again. What was considered dead just a few days before has been resurrected. Only this time, the violence could be twice as bad.
Let’s look at a few examples of this and how to build a low risk long strategy around this theory.
Liquidity Trap Example #1: HLBZ
HLBZ was a recent example of a liquidity trap. We referenced it above in Nate Michaud’s tweet. Let’s look at the charts to see what we can glean from the setup.
Notice the callouts on the chart. We get the big outlier day with a reversal. This pulls us into an area of prior resistance, which could become support.
Paying attention the next morning, we can look to enter this stock as it crosses the pivot low of the gap day. Our risk is defined below the second candle. Otherwise, you could simply set a 3-4% risk below the intraday low of the outlier day. This is discretionary and will depend upon your position size and the volatility of the stock.
Let’s now look at what happens the next morning pre-market, and how we end the day:
Sure enough, the next morning a catalyst came in the form of positive news for the company. As demand piled into the premarket, shorts were left scrambling to either cover or average up their positions from two days prior. The price of the stock quickly surpassed all resistance areas from that day.
Similar to VWAP Boulevard
We’d like to note before moving forward that this setup is somewhat rooted in the theory of vwap boulevard. The correlation here lies with the “average” of the shorts that pile in on day one. Using vwap from that high volume day can give us a gauge as to where shorts starts sinking. Think of it like a watermark.
If unfamiliar with this strategy, definitely check out our guide and give AllDayFaders a follow on Twitter for more info.
Liquidity Trap Example #2: WHLM
WHLM provided another great liquidity trap opportunity in 2021. Volume dropped from 17 million on the momentum gap to less than 600k the next day. But notice the key levels that held so well:
Just like the prior example, on the second day we hold a prior area of resistance and close near the intraday low of the big gap. As price increases, we see it touch vwap boulevard from the gap day, denoted by the purple line at $8.21. The third day, shorts can no longer hold the line.
The rest is history.
If you had initiated a position near the pivot low on the second day, your risk/reward would have been phenomenal. You might have started in that day, and set price alerts as key price levels held, adding along the way.
Ultimately, vwap boulevard could have provided another low risk add-on buy as it held the fourth day, giving us a spring board for the breakout.
More Liquidity Trap Examples
Now that you have the basics of the strategy, let’s see if you can test your own “chart eye” with the following examples:
Notice how with each of these examples, we have an igniting gap that gets sold into. The days following are low volume compared to that day as price inches upwards toward a new breakout.
Your goal as a trader is to find the best risk to reward entries and ride this momentum while managing risk if it fails. You can do this any number of ways as we have mentioned above.
If the stock doesn’t pull all the way back to the gap intraday low, you might consider using the lows of the second and third pull-back day as your risk.
Things to Consider
As with any strategy, there are always a lot of caveats. Liquidity traps don’t work 100% of the time. It is up to you to study the strategy and find the subtle nuances that may help your success.
Along those lines, the following are worth considering when identifying these traps:
A great thing to do with this strategy is to start in small and add if the trade continues in your favor. As you study charts, you may identify certain criteria for starters, adds, and removing shares if the stock hits targets or fails to meet your expectations.
As we discussed above, it’s best to use your daily levels to give yourself a bigger picture idea of support and resistance near term. You might even use a lower time frame like a 30-minute or 1-hour chart to identify key levels.
Keep in mind, this is a short term swing trading strategy. To that end, be sure to pay yourself along the way.
Practicing in the Sim
One of the best ways to spot these opportunities is by using TradingSim‘s scanner. You can run through over 3 years of data identifying daily gappers, filtering your results by float size and other criteria.
As you run through charts, identify those gaps that ran, pulled back, then found support and carried higher.
Make notes and screenshots of all the candidates you find, save them in a OneNote or other platform, and discover your edge criteria.
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