How can you profit from stocks at risk of a 'short squeeze'?

Identifying stocks that are overvalued and betting that they’ll fall in price is one of the most extreme brands of value investing out there, and for short sellers that were active ahead of the the 2008 market crash it was also one of the most profitable. But while tireless research into overstretched stocks can produce sizeable returns when they collapse, getting it wrong or seeing the market turn against you can lead to a dreaded short squeeze. Despite being a byword for panic for canny individual investors a short squeeze can actually be a useful indicator of not only when to sell, but when to buy as well.  Let’s investigate.

What is a short squeeze anyway?

A short squeeze typically unfolds when a stock that’s being shorted by investors unexpectedly rises in price, rather than falls. After borrowing shares from a broker to then sell in the market, a rising price not only creates an instant paper loss but as other shorters scramble to buy back stock to cover their positions (either to stem losses or meet margin calls), the price can rocket.

At this point it hardly matters if the stock remains grossly overvalued or destined to eventually fall for as the squeeze tightens short sellers will feel the heat. Deciding to exit the trade then comes down to individual risk appetites, time horizons and financial clout.

What happens when the shorts get it wrong?

A good example of shorts getting burned occurred last year with supermarket delivery group Ocado. With it’s sole Waitrose contract, Ocado IPO’d in 2010 at a 180p flotation price that some analysts felt was a bit much even then. By March 2013 it was one of the most heavily shorted stocks in the market, with around 15% of its shares out on loan - a huge number. But that same month Ocado bagged a delivery deal with Morrisons that triggered a relentless rerating that saw its price rise by 200% through the year. The massive price hike was magnified by this big unwinding of short positions,  leaving just under 4% of Ocado’s stock on their books at the end of the run.

What tools are there to spot when the shorts may be shaken out?

Researchers who have studied the mechanics of short squeezes have suggested that it’s possible for short sellers to spot the warning signs early. Not only that, but a short squeeze indicator can also give long-only investors the chance to trade on the price rallies that can occur during a shorting shakeout. For both sets of investors, a short squeeze can be the first sign that a company has turned a corner, that its fortunes might be changing and that sentiment towards it is warming.   While short sellers are famously smart sellers, they do occasionally get it wrong and rising prices can be justified. So what do you look for?   

Hedge funds and researchers tends to focus on three key signals for signs of high short squeeze risk:

1. The percentage level of Short Interest in a stock.
2. High share price volatility
3. The Short Interest Ratio (otherwise known as Days to Cover).

 

As we’ve discussed previously, analysing short interest - or the percentage of shares sold short in relation to the overall number of shares outstanding - can shine a light on the companies that short sellers love to hate. But the level of short interest can also offer an indication of how severe a squeeze could be if the share price started to climb. With larger numbers of traders leaping to cover their positions, stocks with high levels of short interest can be prone to more extreme squeezes.

In addition, heavily shorted stocks with relatively high medium- and long-term price volatility (often found with smaller shares) are also more susceptible to the types of large price movements that can trigger a short squeeze. In these cases, heavily shorted, highly volatile shares that are falling in price frequently see very sharp price run-ups with the potential to panic short sellers out of the trade and trigger a short squeeze. 

As well as short interest and price volatility, potential short squeezes can also be identified by using a signal called Days to Cover, which predicts when short sellers are likely to step in to cut their losses. It works by analysing how long it would theoretically take for a company’s shorted shares to be covered if all the sellers decided to unwind their positions at once. That’s worked out by dividing the number of shorted shares outstanding with the stock’s average daily trading volume. If, for example, a company had 10 million shares held short and an average daily trading volume of 2 million, then the Days to Cover would be 5 (5 days for all those shorts to be covered). Analysts use the ratio to measure the sentiment around a stock - the higher the Days to Cover, the more likely that short sellers will act to stem their losses and the more extreme a short squeeze is likely to be.

How can you access short interest data on the web?

Of course, these sorts of data points are generally only available to smart money institutional funds but the great news is that in the coming weeks we’ll be will be introducing Stockopedia’s own Short Interest Rank and Short Squeeze Indicator. These tools will blend the best of the above ratios to help investors get a detailed insight into which stocks are being short sold and when those positions are coming under pressure. With this insight it will be possible to get a much more informed view when opening a short position or, for long-only investors, see the moments when previously shorted stocks could be about to rally.

Not only this, but we’ll be merging our Short Interest Rank, Insider Rank and Institutional Best Ideas Rank into an overarching ‘Smart Money Ranking’ for every stock in Europe, and later the world.  If you want to be one of the first to on the list to test out our new Ownership features and piggy back the smart money - please sign up here.