Profit From Short-Squeeze Candidates

In 2004, investors of Travelzoo (Nasdaq: TZOO), a small online travel site, saw their shares gain more than +1,000% in just a few months -- thanks to a "short squeeze" of unprecedented proportions. And while this meteoric rise was painful for those short-selling the stock, long investors cheered the gains. But what exactly was behind this run-up, and how can you find other stocks ready to do the same thing?

As long investors, we can always take comfort in two things: our stock picks can never drop below zero, and theoretically they have unlimited appreciation potential. In other words, if you buy a stock at $20 per share, the most you can lose is $20 per share, and there is no cap to the potential upside -- the sky's the limit.

However, the situation is exactly reversed for short sellers -- those betting that a stock price is headed lower. In this case, potential gains from a declining stock are limited, and should the short seller guess wrong, then the downside risk is infinite. That's why fearful short sellers worried about a sharp rally are often quick to bail out of their positions. Fortunately for everyone else, this can be the perfect time to act.

To cash in on a price decline, the process for short sellers is rather simple:

1.)  Borrow shares from a broker, and sell them on the open market.
2.)  Wait for the share price to fall.
3.)  Buy the shares back at the lower price to return to the broker and close out the position.

Essentially, this is the reverse of buying low and selling high -- first you sell high and then you buy low. If the stock price drops from, say, $30 per share to $20, then the short seller pockets an easy $10 gain. Of course, if the stock moves up and they finally throw in the towel at $40, then the short seller will lose $10 per share.

If other short sellers decide to get out when at the same time, then all those buy orders (remember, a short seller must buy the stock back to close out the position) will push the shares even higher. At that point, any remaining short sellers who might not have been quite as jittery may get nervous and bail out as well, pushing the shares even higher still.

Like an avalanche gaining momentum as it rolls downhill, each wave of short covering causes the stock to rise, which triggers more short sellers to come out of hiding, which sends the shares even higher, and so on. This process is known as a "short squeeze," and it can lead to huge gains in a short period of time.

Two investment tool that can be used to spot a short-squeeze opportunity are the short interest percentage, and the short interest ratio. 

To calculate the short interest percentage, divide the short interest -- the number of stocks that are currently shorted --  by the number of shares outstanding (NAV47).  This will calculate the percentage of stocks issued that have been shorted.  For example, if 100,000 stocks have been issued by company XYZ, and 25,000 have been shorted and not repurchased, the short interest percentage is 25%.

The higher the short interest percentage, the more likely it is that there will be a short-squeeze.  It can be used to gage both present market optimism or pessimism, and future market demand for a stock.  A large short interest percent indicates a bearish present outlook.  However, it also indicates future demand for a stock since every short position must eventually be covered.   

The short interest ratio is calculated by dividing the short interest by the average daily trading volume over a given time.  If the average daily trading volume for company XYZ is 5,000, and the short interest is 25,000, then the short interest ration would be 5; the ratio represents the amount of days it would take on average to cover all the short positions.  A short ratio of 5 or above is a good indicator that a stock might be bullish in the future, and is a prime canidate for a short-squeeze.

It takes strong nerves to climb into a stock with a lot of short sellers. However, those who do can clearly reap huge rewards -- even when a rapid short squeeze doesn't materialize. Why? Because shares that are sold short represent a massive block of pent-up future demand -- these shares will all be bought back eventually, it's just a matter of time. And for a small, thinly-traded company, sometimes all it takes is a spark to ignite the powder keg.

For example, in early 2004 traders had a very bearish outlook on Travelzoo, and nearly all of the firm's available shares were sold short. However, within a few months the stock began moving, climbing from below $10 to a new record high of $15. As short sellers rushed to cover their short positions, the stock began to skyrocket. That, of course, attracted buying interest from the momentum-investing crowd, which only further accelerated the gains. When the dust finally settled eight months later, TZOO had rallied more than +1,000% to reach a peak of roughly $100 per share.

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