How Can You Make Money with a Short Squeeze?

bigstock-Dollar-Squeeze-43732813Dear Mr. Market:

If you’ve ever taken a course in Economics hopefully the one thing you retained was the law of supply and demand. Heck…even without a formal education in economics you still know what it is. Have you ever been to a ballgame or an amusement park on a scorching hot day and overpaid for an ice cold drink? You didn’t pay a higher price because of increased quality. When there is a lack of supply but there is excessive demand the price is going up. This same fundamental economic concept is what drives the share price of a stock rapidly higher during a “short squeeze”.

First off when a large amount of investors are “short” a stock they obviously want the stock to plunge. It’s the opposite of “buy low and sell high”…Shorting stocks is simply “selling” it high and buying it back lower. If the company they’ve shorted reports some good news and the price increases it basically creates a rush of buying activity among the short sellers. Short-sellers rush to close out their short positions and buy the stock back to cut their losses. This short-covering adds fuel to the fire and the price of the stock pops even higher.

The perfect scenario for a true short squeeze to occur is when there is a fairly limited amount (supply) of shares and a high level of short-interest. The number of shares available for trading is called the “float” of a stock. “Short-interest” is the amount or percentage of shares sold short that investors have not closed out or covered yet. Data on float and short-interest is easily available online.

http://wsj.com/mdc/public/page/2_3062-nasdaqshort-highlites.html

How can you potentially profit from this?

First off, reading short-interest data on stocks you own or are interested in can be an excellent way to gauge investor sentiment. We often mock the “herd” mentality but in some cases you can see what institutional and large players are thinking. If you see consistent increases in short-interest it warrants checking out specific news or digging into what headwinds that stock might be facing.

Many contrarian investors look for stocks with high short-interest. The simple idea here is that once there is an overload of negative sentiment and the stock has basically been pushed down almost as low as it can go, a reversal can take place. Higher levels of short-interest can certainly indicate investors becoming more bearish but much like a rubber band it wants to eventually snap back to the other extreme. A decent or positive bit of good news on the company sparks some buying which then can quickly trigger a dramatic short squeeze.

Look for stocks that are smaller in market capitalization (size) and also those with smaller float (supply). While it’s not impossible to see a short squeeze in a company like Intel (INTC) or General Electric (GE) the odds are less likely since they have billions of shares in their floats.

Along with a high level of short-interest on a stock you need to look at the “days to cover”.  This ratio is a decent indicator of how pronounced a short squeeze could be. “Days to cover” (DTC) gives you a measurement of how many days it would take for short-sellers to close out and buy back their positions.

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The longer the number of days it takes to cover the more potential and drawn out a short squeeze could be. Don’t just rely on this number alone, however, as that could be a recipe for disaster. Some traders look for a DTC number of at least five while others are north of eight. There is no magic number but you do need to have other factors work out for you as well. Along with the beginnings of a price reversal you need to be on the look out for increased volume. If both of these criteria are in play you could have potentially found a nice entry point for a short squeeze.

The bottom line is this: Most of the above data and strategy is used by professional traders. Trying to predict a short squeeze is almost as risky as trying to simply short a stock anyway. One thing you can at least use the data for is gauging investor sentiment on your holdings. Keep in mind that short sellers are often wrong but you at least know what most folks are thinking if you see a big change in short-interest.

If you have any questions on this or want to know a few stocks on our current radar with this type of criteria…email us directly at info@myportfolioguide.com.

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