Squeezing the Shorts: Small-Cap Stocks

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By Jonas Elmerraji

BALTIMORE (TheStreet) -- Don't discount the power of the small stocks. While most investors spend their time focusing on big blue chips, small- and micro-cap investors are reaping the benefits of bigger price swings and a lack of analyst coverage. And when it comes to short squeezes, small-cap stocks (those with market capitalizations of $2 billion or less) provide some of the most serious gain potential.

Price swings and little analyst attention don't typically sound like good things for a stock that you're thinking about investing in. But when you're talking about a potential short-squeeze play, they can be.

A short squeeze is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors. As more and more of the short investors buy shares to cover their positions, share prices skyrocket. Almost anything can trigger a short squeeze, including trumping earnings expectations, winning a lawsuit, unveiling a new product and even announcing a management change.

With lower trading volumes than more high-profile stocks, bigger price swings are inherent in the small-cap world. But that also means that fewer shares can push a small-cap up much higher during a short squeeze. And a lack of analyst coverage means that investors who are short the stock could easily miss some of the company's more qualitative benefits.

One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which divides shares short by average daily trading volume in order to get a ballpark estimate of 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.