The art of short interest

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As the market falls, many stocks are experience large amounts of unusually high short interest.  The shorts have made there money in a few select stocks, which are bound to recover as the institutions start buying back stock to cover previous shorts.

Short interest for the contrarian

Short interest is one of the best tools a contrarian investor has. Short interest is usually stated in a large number, which is the amount of shares that are sold short, as well as a smaller number, indicating the amount of days of average volume needed to recover all shares short. The higher the ratio of number of shares sold to average volume means that the investors holding short shares will have to force volume up – and ultimately price to rid themselves of their shares.

In heavily beaten down stocks, there is likely to be a huge amount of short interest. Case in point: Bear Stearns fell from the $90s to $4 within a few days as the JP Morgan buy out emerged. Prior to the news and a share price of $4 per share, there was plenty of short interest. Institutions were weary of Bear Sterns from the get-go and had huge amounts of shares shorted. On January 31, the stock had 3.4 million shares sold short, or 10 days worth of average volume.

Short sellers have to buy back in

As the buyout hit the newswire, the price of Bear Sterns fell to just $3 per share. The short sellers were still holding on for the $2 per share promised by JP Morgan, which would amount to another rung on the profit ladder. As news emerged that JP Morgan revised their bid to $10 per share, the price readily moved as high as $14 per share, – not because investors wanted more, but because buyers were everywhere.

In this scenario, the price should have moved to $10 per share, as JP Morgan released their final bid of that amount. But because of the large amount of short interest at the time, now 3.5 million shares, the market had to absorb 3.5 million in share purchases. This pushed the buy price up as short sellers wanted to ditch the stock at any price. Now the stock trades back at $10.11 per share, short sellers are out, and the only people holding on are those waiting for a complete buyout by JP Morgan.

As you can see, short interest forced investors to buy stock to cover their shorts. This creates a huge demand for the stock and pumps up the value. After market swings like we’ve seen in the last month, there are plenty more stocks that have large short interest beyond what they should. When stocks are sold short at high daily volume ratios, they are said to be in a short squeeze; even with modest news the sellers will have to buy as the company gains ground.

Current short squeeze

One example of a short squeeze in the making is a company known as Thompson Corp. Currently, there are 35 million shares sold short, which is 105 times the daily volume to cover. The stock trades with a low PE ratio of 5, but has a very slow growth rate at 4%. This stock might have slow growth, but any future news can easily push the price up. It would be very difficult for any future shorters to obtain this stock and very easy for the market to turn on them.

Small issue with short stocks

One problem with the short squeeze is the catalyst variable. Many stocks held in a short squeeze need some type of catalyst to push up the price. This usually comes from better earnings outlook as people don’t want to sell short a growing company. Boring, slow moving companies will have a hard time breaking out of a short squeeze and usually require a buyout or great news to send them upward.

Look for big companies

The best short squeezes are found on high volume, profitable companies. Corporations that have advanced at breakneck rates are often exposed to a short squeeze as institutions sell short to lock in short term profits. Afterwards, the price rebounds, as all the shorts have to buy back shares to cover within a matter of days. This can send the price moving up as bid prices rise to coerce shareholders to sell their shares.

The short squeeze is best played with an options strategy to minimize the risk of a stock dropping and maximize the gains in a huge run-up. Options near the price trade at very small premiums, but offer the same upside potential as the stock itself. For this reason, buying options is the best way to make the most out of a short squeeze, while protecting yourself from any large falls in stock price or any future selling.

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