Aggressive Stock-Picking, Week 5: How to Squeeze the Shorts

Ready for a trading challenge? Learn how to make money on the short side.
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Editor's note: The Aggressive Stock-Picking Training Program is a series of six weekly assignments. To start with Week 1, click here. Each assignment is based on one of James Altucher's strategies in his book, Trade Like a Hedge Fund. To get a copy of the book, click here.

This assignment was written by Stockpickr member Ira Krakow.

Many professional traders make their money

shorting stocks, betting they will go down. Shorting a stock involves borrowing the stock from a broker, creating a

short position. The trader can only recognize a profit if, after the stock has decreased in price, the position is closed by buying the stock on the open market (see

"Ask TheStreet: Short Squeeze"). This is called short-covering.

Another statistic to measure the potential intensity of a "short squeeze" (a rising shorted stock forcing buyers to rush in and buy the stock) is days to cover -- the number of days a short-sellers needs to buy back shares to close their positions. The greater the number of days to cover, the more intense the short squeeze can be.

The short ratio is the percentage of a stock that is shorted (see

short interest). One of the best ways to find a short-term trade is to look for a stock that has a high short ratio, say 10% or more. Here's why: The higher the short ratio, the more days it'll take short investors to cover their bearish bets should the stock rise from a jolt of good news.

A heavily shorted stock has the potential to soar on any positive catalyst, because so many investors are placing bets against it. This creates an opportunity for aggressive buying -- in other words, betting against the "shorts" that the stock will experience a short squeeze.

The Stockpickr editors are always on the lookout for those 10 stocks that are the best short squeeze candidates. As an example, Check out the

short squeeze candidates for the week of August 25, 2007

.

Two examples from that list should show you what you're up against. Take subprime mortgage company

Fremont General

(FMT)

, which fell 12% to $4.06 on Aug. 28 after Moody's cut its senior-debt rating (see

"Tuesday's Financial Winners & Losers" ). There's a chance Fremont General could eventually become bankrupt, with its stock price falling to mere pennies, or becoming worthless.

But stocks don't fall in a straight line. There may be some short-covering on the basis of some positive news, such as the Fed lowering the discount rate or the government bailing out subprime borrowers.

Another stock with heavy mortgage exposure,

Thornburg Mortgage

(TMA)

, has high short interest (see

"Rocket Stocks For the Week of September 4th-7th") Thornburg can easily move up on short covering, sometimes very quickly.

Sometimes a heavily shorted stock is not actually a short-squeeze candidate. Take

Thomson

(TOC)

, which has a whopping short interest ratio of 85% (see

"Top 10 Short Squeeze Stocks of the Week"). Thomson has been unsuccessfully trying to sell its Thomson Learning division to private equity firm

Blackstone

(BX) - Get Report

.

With the problems in the credit markets, this deal is in trouble. However, Thomson's

fundamentals are good. The company recently reported a 118% year-over-year increase in quarterly earnings on an 11.1% increase in revenue. The stock has a

P/E of 19 and a

PEG of 1.6, and it pays a yield of 2.4% (see

"Top 10 Short Squeeze Stocks of the Week"). Its stock might rise if the market recognizes the company's intrinsic worth. At that point, the shorts would need to cover, creating an apparent short squeeze.

However, the real reason for the heavy short interest is that

Reuters

(RTRSY)

agreed to be acquired by Thomson last May. The deal comprises approximately 50% in Thompson stock. There's still a 10%

gross spread there, thus the short pressure on shares of Thomson.

Sometimes a large number of stocks in an entire sector are subject to short squeezes. Last week, in his article

"Three Potential Short Squeezes" , James Altucher featured

Dendreon

(DNDN)

, as a biotech company that has been the subject of several short squeezes over the course of 2007.

Looking at a

chart in the March-to-May timeframe tells the whole story. On March 30, Dendreon's shares shot up over 250% from its March 29 close, because of rumors of FDA approval of Dendreon's anti-prostate cancer drug, Provenge, producing a monster short squeeze (see

"Dendreon's Revenge"). There were a number of short squeezes (the shorts were betting that Provenge would fail) in Dendreon in the next month as well, producing opportunities to make a huge profit if you could anticipate the move.

Biotech stocks are especially vulnerable to short squeezes because they trade almost entirely on news, particularly when related to the success or failure of FDA clinical trials (see

"Top 12 Biotech Short Squeeze Stocks" and Stockpickr's

Biotech Short Squeeze Portfolio ).

Please Note: This Is a Very Aggressive Strategy

These stocks tend to have violent price swings. On Aug. 10, for example, Thornburg opened at $21.01. Two trading days later, on Aug. 14, it traded as low as $7.49, based on news of its mortgage funding problems. But the stock didn't rocket down in a straight line from there. Instead, during the next three trading days, it traded as high as $16.40, because of positive news.

Since then, Thornburg has experienced bumps up and down of as much as 30%. Good news from the Fed could cause Thornburg to skyrocket, perhaps in minutes. Bad news will cause it to crash and burn, also in minutes. By outsmarting the shorts, you're trying to catch one of those positive bumps. Warning: This is not for the faint at heart.

You are not planning to hold such a stock for very long -- only a few days or a week or two at most. You have to be prepared to sell instantly. These stocks are frequently accompanied by terrible news. Many times, the negative news is justified. The shorts could be right, after all. Everyone around you is selling. You are acting against your gut instincts, as well as against just about all the so-called experts.

So if you're up to the challenge, here is this week's assignment: Pick the best short squeeze candidates.

Step 1.

On Stockpickr, create a portfolio called "Short Squeezes:

Your Stockpickr Username". (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register at

www.stockpickr.com/register

) Turn the "Porfolio Tracking" feature on, so you can monitor stock prices over time.

Step 2.

Pick four stocks from the latest week's Short Squeezes portfolio on Stockpickr. Read the "Reason for Picking" box to see why each stock made the list.

Step 3.

Read the news about each company, by searching for articles and videos on

TheStreet.com

(via the "Search Articles" box) and other sources. You are looking for reasons the shorts are bearish on these stocks, as well as for reasons they may be wrong.

Step 4.

Do some

fundamental work on all four stocks. Maybe there's some positive news, such as a pending Fed rate cut, that might make the stock bounce back. Or, if the

balance sheet looks clean and the company is not operating in a declining business cycle, the market may recognize that the company is a better investment than it might seem at first. As you do this research work, write your observations in the "Reason for Picking" box for each stock.

Step 4.

Identify two stocks that are either valid short investments or are unjustly shorted, and are thus candidates for a short squeeze. Note your reasoning for your conclusion, and the

closing price in the "Reason for Picking" area.

Step 5.

Follow these two stocks during the next three days. Note intraday trading patterns, including

trading volume and price movement.

When, if ever, should you buy one of these stocks? If you do decide to buy, note the day and the price. Then, decide when you should pull the trigger, to sell the stock after a short squeeze.

Step 6.

Back-test your results. Do this by taking the previous week's Short Squeeze Stockpickr portfolio, identifying two stocks that you might have bought in anticipation of a short squeeze, or checking whether they were indeed good stocks to short, and seeing whether the short squeeze actually occurred.

Homework Hints

Search Stockpickr for other portfolios that include the term "short squeeze." You will find many "pro" and "DIY" portfolios. Outsmarting the shorts is perhaps the most popular, if most risky, aggressive stock-picking strategy, so read the "Reason for Picking" boxes carefully.

Stay up-to-date on James Altucher's short-squeeze articles on

TheStreet.com

. He not only writes a weekly column that identifies potential short squeezes, he also comes up with additional ideas during the week. Many other writers on

TheStreet.com

also identify short-squeeze candidates. See if you agree with their reasoning.

Also, compare your stock-picks with those that appear on several Stockpickr portfolios. For example, in addition to biotech, check out Stockpickr's portfolios for sectors such as:

  • Internet Short Squeezes
  • Homebuilder Short Squeezes
  • Top Tech Short Squeezes, which highlights Amazon.com (AMZN) - Get Report as a stock with high short interest.

You can also compare your stock picks with those on these Stockpickr lists:

  • Stocks With Unusual Options Activity : You're looking especially for stocks with a lot of put options ,because this typically signals bearish sentiment for the stock.
  • Stocks Rising On Unusual Volume : Each trading day after the close, this portfolio lists those stocks that rose the most on unusual volume for that day (see "Aggressive Stock-Picking, Week 3" ). Often, the unusual volume is due to short-covering, so don't be surprised to see your stock picks on this list as well.
  • Unusual Volume System Trades: This is one of Stockpickr's techniques to take advantage of swings in volume, which can be triggered by short-covering. This strategy is similar to others discussed in Trade Like a Hedge Fund. The strategy is: If a stock has 50% higher than normal volume and it's up 1% on the day. Buy at the open the next morning. If the stock is up two days in a row, sell at the open the next day.

After you have mastered the ins and outs of

short selling, you may want to set up your

brokerage account to allow short-selling.

Because it usually involves buying

on margin, you are definitely assuming more

risk if you're wrong. Your loss -- the stock you short can double or triple, for example -- is potentially infinite. Your gain, even if the stock goes to zero, is limited to 100% minus the cost of borrowing the stock and any

dividends the company declares while you are

short the position.

So while most investors prefer to make money by being

long a stock they like -- and simply avoid stocks they don't -- money can be made on the "short side" (

if

you have the stomach for it) as well.

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