Most of us can recall a stock event in recent history such as VW that shot up to over 1,000 dollars per share to double its value in one day. What could possibly cause such a radical event?
The answer: the short squeeze.
We will now analyze this interesting phenomenon by looking at the underlying cause of such a boost which is the "short interest".
What is Short Interest?
When people short a stock by selling shares now and hoping to buy back later at a lower price, this creates short interest. These are shares that need to be bought back at some later date, or a locked in sale so to speak.
The short ratio is the amount of the available share float that is sold short. For instance, if 10 percent of all shares were sold, not by shareholders but by traders shorting the stock, the short ratio would be 10 percent. This number can be as small as zero or much, much higher. How does the short ratio affect the stock?
What Increasing Short Ratio Tells Us
If a stock has an increasing short ratio between months, this is good cause to stop and take look before wantonly buying shares. Investors short sell a stock when the expectation is that the prices will drop. If you can see in the company statistics that the short ratio has greatly increased recently, try to find out why.
- Is the industry group quickly falling out of favor?
- Did the stock recently report some negative news item?
- Were future growth forecasts lowered?
The point is that a red flag should be raised when you see increasing short interest.
Be Wary of Joining the Pack
By now you might be thinking ahead and want to pick stocks with a very high short interest ratio and short sell yourself. There is safety in numbers isn't that true? Before throwing your lot in with the high percentage of short sellers in a certain stock, first look to how many days it will take to cover the short interest.
For instance, if the stock has an average daily turnover of 100,000 shares, and 1 million shares are sold short, there would be a 10 day period to cover all shares. But even this number is not correct since the average buying and selling of shares represent the 100,000. If all short sellers needed to buy back in within a short time frame, this would be in addition of the daily turnover. Ask a large institutional investor and he will tell you that you can only purchase a small percentage of the daily turnover without vastly affecting prices.
The lesson is that if buying back in takes roughly two trading weeks to fully cover the total short position this could be too long. In the above example there needs to be 10 days to cover at 100,000 shares per day. This increases the traders risk since he cannot quickly cover. Of course, if you are assuming a small position this may not be a big consideration.
High Short Interest and Short Squeezes
The short squeeze is an interesting concept. If a very high percentage of shares have been sold short, this creates a profitable opportunity if there is suddenly high buying pressure.
Does this mean that we can merely screen for stocks with a high short interest ratio and buy with the hope to profit from a short squeeze? No. Consider a reason why...
The stock might truly be declining in value over time without any upwards impetus. The stock could drift lower and lower into potential bankruptcy. Regardless of how high the short interest ratio, no squeeze would be created. The high short interest ratio in this example is merely a reflection of the negative investor confidence in the stock.
That being said ... if you have a basket of stocks in a new uptrend, or are trading a stock that just released very positive news, look to the short interest ratio. Any number above 10 percent is considered by some to have the potential for a short squeeze. Remember, a short squeeze can only occur if there is a trend reversal and prices start to move rapidly.
One last point to remember, a stock with a very small float will have the ability to have a more pronounced short squeeze. If most of the stock is tied up with institutions and insiders and few shares are available, there could be a panic buying situation during a strong uptrend in the stock.
Final Thoughts on Short Interest Ratio
While some traders will try to screen and trade stocks with incredibly high short interest ratios, most do not use this as an exclusive screening criteria. But knowing if short selling has vastly increased does give a clue as to the health of a stock. Also, if a stock is popping upwards and it has a short ratio of 10 percent or more, this could be a causal agent for having lift-off of NASA proportions.
Example of Short Squeeze
For instance, a stock might be trending lower and lower due to declining earnings. More and more short sellers keep piling on and the short ratio reaches 30 percent.
Suddenly and unexpectedly there is a turnaround. The company secures some very lucrative contracts that guarantee a massive boost in bottom line profits. As buyers come flooding in, share price rises. As the prices go up the short sellers begin to cover so as to lock in profit. This creates even more buying pressure.
Suddenly as the prices rocket the brokers contact the remaining short sellers and insist that more money be placed in the account to satisfy margin requirements or to close out now. This creates panic covering and prices go through the roof.