The Only Safe Way to Profit on a Short Squeeze
By Jeff Clark
May 19, 2009

Anyone who has been on the wrong end of a short squeeze knows the pain of being run over by a crowd of stampeding bears as they rush to cover a bad trade.

Stocks that are popular short sales one day can become popular purchases the next. And the momentum behind the move can bolt a stock 10%-20% higher in a heartbeat.

A large short interest provides the first clue of an impending squeeze. It's like the thin, finger-like clouds that blanket the sky two or three days before a thunderstorm.

Short interest refers to the amount of a company's stock that is sold short. Three to four days' worth of average volume sold short is enough to provide kindling for a short squeeze bonfire. But it's the companies that have 70%-80% or more of their available float (stock held at custodial institutions and available for short sellers to borrow) sold short that are vulnerable to an inferno.

Indeed, many analysts recommend stocks with the largest short interest as they are most susceptible to quick, large bursts higher. But there's a problem with that strategy…

It's one thing to bet against Mom and Pop short sellers who can spook easily and don't have deep enough pockets to hold a short sale through a violent upside move. It's something entirely different to bet against the institutional short sellers.

It's a good bet any stock with more than 40% of its available float sold short has institutions betting on its demise. Institutions have the experience and, more importantly, the money, to carry a wrong-way bet in the short term as long as the fundamental premise behind the trade hasn't changed.

In other words, institutions aren't going to panic and rush to cover a short trade moving in the wrong direction.

Think about it… General Motors has something like 45% of its available float sold short, and it has been that way for over a year. Traders buying into GM stock in anticipation of a short squeeze, however, are the ones getting burned. While the stock has experienced a few brief rallies along the way, GM has never veered far from its path toward bankruptcy, and every small rally has been followed by a deeper decline.

The same is true of most troubled financial stocks, most over-leveraged homebuilders, most cash-strapped retailers, and just about every other sector that tops the "largest short interest" list.

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Be careful when betting in favor of a short squeeze. Stick with fundamentally decent stocks with several days' worth of average volume sold short. That's more than enough to provide the spark that lights the fire.

Stay away from stocks that are institutional favorite short sales. Buy them at the wrong time, and you'll be the one getting burned.

Best regards and good trading,

Jeff Clark