Buying stocks that have been heavily shorted isn't a strategy that most people feel comfortable with. But it can reap big, albeit fleeting, rewards when the market suddenly turns up.
That's because stocks with high short-interest ratios -- or high levels of short interest relative to their average daily volume -- are often susceptible to a short squeeze. Short interest refers to the number of shares outstanding that have been sold but not yet bought back. A short squeeze occurs when stocks rally and traders have to buy back shares they have sold, pushing prices even higher.
Although it's unclear whether stocks will experience a bear market rally any time soon, it's worth taking a look at some of the shares that could see the biggest gains if and when such an event occurs.
Topping the list is
, a health and life sciences company based in Canada. The firm has a short interest, or "days to cover" ratio, of 141.73, meaning it would take more than 141 days for short traders to cover their positions if some good news suddenly took prices higher.
Usually short traders look for stocks with a days-to-cover ratio of around 7 or less because the stock is less likely to encounter a short squeeze. A low days-to-cover means the short interest can be quickly wiped out and short traders aren't likely to feel too much pain if the stock unexpectedly goes up. A high days-to-cover ratio, on the other hand, suggests that most of the people who wanted to sell the stock have done so already and that further declines aren't very likely.
Among other companies that could face sizeable gains in a market upswing are
( IQW) and
, all of which have a days-to-cover ratio of more than 80.
But it's not just relatively obscure names that could benefit from a sudden uptick in the market.
has a days-to-cover ratio of 90, while
Level 3 Communications
has a ratio of 20.5.
have short interest ratios of 12.7 and 10.7, respectively. And
( GTW) and
all have ratios of more than 9.
Another indicator for investors to look at is the put/call ratio on any given stock. Put options allow traders to sell stocks at a certain price at a certain date in the future, while a call option allows traders to buy a stock at a certain price and date in the future. If there are many more traders buying puts than calls, it's a sign that they believe stocks are going to decline. But a high put/call ratio is a contrarian indicator, suggesting that bearishness has reached such an extreme that it could be time to start buying.
Among companies with high put/call ratios and high levels of short interest are
"I think savvy traders think, well, there are so many shorts out there, there's going to be a squeeze, but the general public probably thinks something is wrong with the stock and so they jump on the bandwagon and short it too," said Jerry Byrne, hedge fund manager and contributor to
Still, Byrne said he looks at the short interest and put/call data as informational tools only. "I don't use the numbers to go long off of and hope for a short squeeze," he said. "So much of the volume is part of an arbitrage trade or part of a hedge, so stocks are usually shorted for a reason."
Tim Truebenbach, president and general partner of True Capital Management, said he too observes short interest, but uses other methods to identify buying opportunities. Specifically, he looks for companies that are breaking through resistance levels on heavy volume.
"I follow other strategies, but if a stock has a high level of short interest, that might be a fringe benefit," he said, adding that the main problem with going long when all others are going short is that it is a difficult strategy to time.
Indeed, there's no telling when or if some good news will push stocks higher, or how long that rally will last. After an initial bout of short covering, it's quite possible that investors put on more shorts either as a hedge or because they believe the firm's prospects are weak. Still, a security's short interest and put/call ratio should at least be one consideration for investors when deciding whether to buy a stock or sell it short.