The nice one today was ERNA. Good example of one variation of a liquidity trap. I’ll discuss that idea a bit tonight instead of doing a regular watchlist.

There are many different versions of liquidity traps but instead of listing all the chart shapes they come in, I’ll just talk about the main idea.

Almost all liquidity traps have 3 parts to them. 1 – The initial run up, 2- the consolidation where volume dries up, and 3 – the cover. 

To help visualize this process, I’ll use an analogy.

Using the analogy of a party – there is 1. the invitation (of shorts), 2. the party dies down (volume dries up over the next few days), 3. everybody needs to leave (they try to sneak out but end up making a huge scene). 

Look at the chart I have on here from left to right.

1. That first run up to a dollar with tons of volume is the invitation. Shorts are waiting for this crap company to exhaust out and then they want to ride it down. They see there is tons of volume so they can size in with no problem. And then the trade works. The company fades back down very smoothly. So aggressive shorts had a smooth ride down with no issues and may still have size. 

2. Now the stock has fallen by a good amount and goes sideways. Just drifting and chopping. No real panic or reason to scare swing shorts out. It’s not really going down anymore, just drifting sideways. But while the stock is stable, look at the volume in the middle of the chart. It totally dries up. 500M on day one to 5M next day to 2M next day to 1M the next day. So swing shorts may still have size in there but the liquidity is totally gone. 

3. Time for shorts to get out. Whether its prompted by broker / clearing houses or just because the stock starts to grind up, all the shorts still in there need to think about getting out now. But every cover can move the stock up, and the higher it moves the more it motivates other shorts to cover, and then everyone tries to exit at once and the stock squeezes. Why? Because there is a lot of buying from covering and there is no liquidity. So demand is a lot greater than the supply and price rises. 

That is the essence of a liquidity trap. They may come in all kinds of forms and chart shapes, but they have those 3 parts. 1 – The initial run up that attracts the shorts, 2 – the volume drying up over a few days, and 3 – then the cover comes in when there is very little liquidity. 

So how does a liquidity trap end? When the cover is done, the squeeze is done. Pretty simple. And the way I measure that is by looking at the volume while the squeeze is happening. I often say that the share price mirrors the volume during squeezes. If that cover is done then the stock usually fades down unless more buying comes in from new longs.