BALTIMORE (Stockpickr) -- It's been a rough year to be a short seller. Since January, the S&P 500 has climbed a whopping 26.4% -- and with the new all-time highs that the big index hit this week, it's not showing any signs of slowing down.
All the way up, stocks that short sellers thought were too expensive to begin with have gotten more expensive. That doesn't exactly do wonders for your conviction in a trade. As the old saying goes, "I don't mind being wrong -- but I don't want to be wrong for long". So when shorts start to cover their bets, it could fuel a short squeeze in some of Wall Street's most hated names.
Historically, that's not out of the ordinary. In fact, buying the most hated and heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28% each and every year. That's some material outperformance during a decade when decent returns were very hard to come by.>>5 Breakout Trades for the Final Stretch of 2013 When I say that investors "hate" a stock, I'm talking about its short interest. A stock with a high level of shorting indicates that there are a lot of people willing to bet on a decline in its share price - and not many willing to buy. Too much hate can spur a short squeeze, a buying frenzy that's triggered by shorts who need to cover their losing bets. And with the rally we've been since last November, you can probably guess that there are lots of losing open short bets. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed. It's worth noting, though, that market cap matters a lot. Short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same method was used.
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