Identifying A Short Squeeze

Short selling is a strategy that attempts to make profits from a decline in share value by selling stock at a high level and repurchasing these shares at a lower price. Once a trader enters into a short position they represent future demand because they must cover their trade and repurchase the shares in order to make a profit, or if the trade goes sour, repurchase in order to avoid a huge loss. This is what really gets a short squeeze going. When you sell a stock short the potential loss in theory is unlimited. It is this fear that will cause traders to cover their short positions when a stock’s value starts to rise rapidly. A “short squeeze” occurs when stocks with a large short interest rise rapidly because traders who are short start buying shares in order to cover their position. Short interest is the number of shares that have been sold short but have not yet been covered. The short interest ratio is short interest divided by average daily volume. It represents how long it would take sellers to cover their short position. If the short interest ratio were 5 it means it would take shorts 5 days to cover their positions. The website that I use in my analysis to identify a good short squeeze candidate is http://www.nasdaq.com/. We are generally looking for the short interest ratio to be greater than 5 or 6. Once we have identified the short interest ratio we must look at the chart to further weed out our potential short squeezes. First, eliminate any charts that are in a downtrend. Short sellers of these stocks are in a favorable position so we must ignore them. We must then turn our focus to stocks in an uptrend. We can do this by looking at stocks that are trading above their 50 day moving averages and are at or approaching new highs. At this point we have found a stock that has a large amount of short sellers that are losing money because the stock is at new highs. Now we need to find where the short position was initiated. How do we do this? Well when we go to nasdaq.com we will be able to click on a ticker symbol and see the current short position and any changes in the short position over the past year. This is Healthways Inc. information from Nasdaq.com:

Settlement Date------Short Interest------Average Daily Share Volume------Days to Cover
Dec. 31, 2007-----------7,495,554-----------------543,631-----------------------13.79
Dec. 14, 2007-----------7,483,536-----------------284,231-----------------------26.33
Nov. 30, 2007----------7,066,677-----------------434,965-----------------------16.25
Nov. 15, 2007----------5,261,680-----------------261,353-----------------------20.13

This means that since Nov. 15, 2007 there has been an additional 2,223,874 million shares sold short. Looking at the chart we can see that on Nov. 15, 2007 HWAY closed at $57.97. On Dec. 31, 2007 it closed at $58.44. This means that the shorts are in a losing position. On January 11, 2007 HWAY closed at $68.06. Keep in mind that this is only 7 trading days later. Clearly the shorts that have not covered are in a losing position as the stock has rallied over $10, however, some of them might have already covered their position, but would still need almost 7 days of buying to cover their position (13.79 – 7=6.79). With the shorts extremely nervous about their position they may begin to panic and cover their positions. 7 days of buying surely could act as a catalyst to send this thing higher and is a perfect example of a potential short squeeze opportunity. As with most indicators, the short-interest is not to be used on it’s own. Most short sellers are sophisticated speculators who have done extensive research on the asset they are shorting and often times are right. Many times traders who enter a short position have the right idea but their timing is off. For example, traders often times short stocks that have been in long up trends because the stock is up too high and the P/E ratio is too high. This is why a potential short squeeze candidate must be in an uptrend because we want to catch the shorts bad timing.