Inside the Numbers: Profiting From the "Short Squeeze"

The short seller is the one trader most investors love to hate. Often misunderstood and maligned, the short seller profits when prices fall rather than rise. This doesn't earn the short seller much popularity with most investors (who usually buy a stock hoping it will rise), but it can be a very profitable strategy.

Here's how it works: A short seller thinks a stock's price will fall, so they borrow shares from a broker. They then immediately sell those shares and gets the cash from the sale. At this point, the trader officially has a "short" position in the stock. If the trader is right and the share price falls, they must decide when to buy back the shares at the lower price and return them to the broker. When they do that, the trader pockets the difference from when the shares were originally sold.

If enough short sellers pile on against a stock that's declining, prices can be significantly pushed downward. On the flip side, if short sellers are wrong and a stock begins to rise, a beautiful thing happens for all the "longs" (investors who buy a stock and expect its price to rise) -- short sellers begin to "cover," or buy back their shares. This causes the stock to rise further, forcing more short sellers to cover. If the stock stages a significant rally, it can create panic buying by shorts, causing what is known as a "short squeeze." Of course, this can mean strong profits for investors holding the shares long.

Before we look for stocks that could benefit from a short squeeze, it's important to understand a key metric -- the short interest ratio. This is found by dividing the total number of shares being shorted by the average daily volume of shares traded.

For example, if a company has 2 million shares short and an average daily volume of one million shares, then the short interest ratio is two (2 million / 1 million = 2), meaning it would take two average days of trading for all the shorts to cover. Therefore, a stock with a ratio of, say, eight, would mean that it would take six more days at average volume for shorts to cover than a stock with a short interest ratio of two. But it also means that if a short squeeze does occur, the rally could be much stronger since there are so many more people selling short.

I recently took a look for companies that could experience a short squeeze in the months ahead. In order to qualify as candidates, they must not only have an unusually high short interest ratio, but also be profitable with good long-term growth prospects -- increasing the chances that short sellers could be wrong about the stock.  Here are the criteria used:

- Short interest ratio greater than 7
- Profitable earnings per share (EPS) on a trailing twelve-month basis
- Long-term estimated annual earnings growth of at least +8%
- Operating margins of at least 15%

Here's what turned up:

This list should serve as a great starting point for further research into short-squeeze candidates.

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