by Marc Lichtenfeld, Chief Income Strategist, The Oxford Club
Wednesday, September 5, 2012: Issue #1854
Most of you buy stocks. You hang on to them for anywhere from a few minutes to a few decades. You hope they’ll go up and then you sell for a profit. Buy low, sell high… that’s what we’ve been taught.
But there are other investors who do the opposite – they sell high and buy low. Sounds similar, but it’s a very different strategy. It’s known as shorting stock. A short seller sells the stock first and buys it back later. If the stock is bought back at a lower price, the investor makes money.
Here’s how it works…
Let’s say an investor shorts 100 shares of Facebook (Nasdaq: FB) at $18.
If he buys Facebook back at $12, he’ll make $600, because he bought it at $12 and sold it at $18, even though he did it in the reverse order.
However, if Facebook rallies to $24, he’ll lose $600. He’ll have bought the stock at $24, but sold it at $18.
Remember, though, the sale took place first.
In order to sell a stock that an investor doesn’t have, he has to borrow it from his broker. Sometimes, stock isn’t available to borrow, in which case the investor can’t short the stock.
It’s an aggressive strategy, one that has unlimited risk.
Think of it this way: When an investor buys a stock, the most he can lose is the amount invested. The stock can’t go below zero. However, a shorted stock can go up indefinitely. Imagine what an investor would have lost if he shorted Apple (Nasdaq: AAPL) at $30?
How to Profit From a Short Squeeze
Shorting is a way to take advantage of a stock that falls in price. But because of the extra risk, it’s not for everyone.
However, investors who are bullish on a stock can take advantage of short sellers in a move that’s known as a “short squeeze.”
When a stock that’s heavily shorted starts to rise, existing shorts “cover” or buy the stock back to avoid suffering big losses.
That extra buying by short sellers covering their positions leads to more demand for the stock and pushes it north in what’s known as a short squeeze. Investors who own a heavily shorted stock that gets squeezed sometimes find themselves with a stock moving sharply higher.
Here’s a recent example.
Repros Therapeutics (Nasdaq: RPRX) is a small-cap biotech company. Over 20% of Repros’ float is sold short. That’s a huge percentage.
So last week, when Repros’ stock was moving higher, it’s very likely that shorts started covering their shares, pushing the stock even further skyward…
Above is a chart of Repros. Look what happened on August 30th. There was no news on the stock that day, but as the stock advanced, buyers piled in, moving the price well above $12. Because there were so many shorts in the stock, it is likely that some of them bought back shares to close their position and limit their losses, which added fuel to the fire.
Today, the stock continued to advance above $14. The stock is up nearly 40% in five days – again on no news. That’s likely a short squeeze.
When I was an analyst at a contrarian research firm, the only stocks any of us were allowed to put a “Buy” rating on were those with at least 10% of the float sold short. It was a way of stacking the odds in our favor so that if the stock did start rising, there was another source of demand to push it still higher.
Let’s take a look at a few stocks that could squeeze the shorts if they get going in the right direction:
iStar Financial (NYSE: SFI), which offers financing to the commercial real estate industry, has 21% of its float sold short. The stock is near the top of its yearlong range. If it breaks out above $7.75, you might see short covering that would propel the stock higher.
Movie theater chain Regal Entertainment Group (NYSE: RGC) has a whopping 32% of its float sold short. That means one out of every three shares have been shorted.
Here’s an interesting figure – nearly 26 million shares of Regal have been shorted. Yet the stock only trades about a million and a half shares a day on average. What happens if the company has a strong earnings report or the stock makes a new high on its own?
With Regal also close to its 52-week high, a breakout could fuel a wave of short covering. And considering that 17 times the average daily volume has been sold short, it wouldn’t take that much short covering to ignite the stock higher.
Understanding the forces that can push a stock higher increases your chances of success. And when you own a stock, there’s nothing more satisfying that squeezing someone’s shorts. Well, you know what I mean.
Editor’s Note: In the premium edition of today’s newsletter, Marc tells a select group of our readers about one of his favorite short squeeze candidates. It’s the stock of a small biotech firm with a 13.5% short float, which he’d be happy to own regardless of whether the short squeeze comes to fruition.
In fact, he told me its cash flow and profits are projected to grow 48% per year over the next five years. For more information on Marc’s recommendation today and how to upgrade your subscription for just $5, click here.Finding Potential Short Squeezes for Big Profits,