Why Short Sellers Are Actually a Bull’s Best Friend

This is a syndicated repost courtesy of Money Morning – We Make Investing Profitable. To view original, click here. Reposted with permission.

Last week, I showed you that to beat the market, you need a stock to follow what I call the “FAR Principle.” I need a fast move that is both aggressive and in the right direction.

One way to find FAR stocks is to look for an impending breakout in volatility, just like I showed you.

Now I want to show you another tool I use that’s been at the heart of my trading for more than 20 years – short interest.
When you see why the number of bets that a stock will go down is a great indicator of when that stock will actually surge (and make you a ton of money in the process), it’ll all make sense…

Here’s What “Short Interest” Actually Is

Chris Johnson’s 10 Trading Commandments

I.         The trend is your friend!

II.       Don’t run with the crowd; avoid bandwagon stocks… unless you’re driving.

III.      Don’t pick up pennies in front of a steamroller.

IV.     Cheap can always become cheaper.

V.       The “smart money” rarely tells you what it’s doing.

VI.     Short sellers are a bull’s best friend…

VII.   …so is volatility.

VIII.  Round numbers are natural support and resistance levels – the more zeroes, the better.

IX.     Stocks are driven higher by speculation, not fundamentals.

X.       There’s an exception to every rule.

Click here to learn more about Chris’ paid trading research services….

Unlike volatility, I’m sure most of you are familiar with short interest. So I’ll be brief in defining it here.

Shorting a stock is a bearish strategy in which an investor sells a stock that he has borrowed from his broker. The seller is hoping the share price will decrease so he can buy back the shares at a lower price.

Frankly, I’d rather just buy a put if I’m bearish, but hey, I love options.

Urgent: These Overlooked Gold Investments Have Gained as Much as 7,679%

Short interest is the sum of all shorted shares on a stock that have not been covered or closed out by buying back the stock. Short interest is considered a sentiment indicator that gauges the market’s outlook for a stock.

So the more short interest, the more bearish the sentiment.

But I prefer to be counterintuitive rather than a herd follower. And that means the more short interest I see on a technically strong stock, the more bullish I become. It’s a conviction that’s served (and paid) me well over my years in the market.

So how does that work, and what does that have to do with my FAR Principle?

It’s all about the “squeeze” that happens when a heavily shorted stock starts to rise. That’s when short sellers are forced to “cover” their losing positions on the stock they borrowed. This results in unusually strong buying volume that drives a stock price higher.

Typically, a short squeeze is triggered when the stock rallies enough so that short sellers feel the pressure of margin calls against their accounts, but it can be as simple as the bears – the shorts – wanting to cut their losses and get out.

In an ironic twist, “getting out” involves buying shares of a stock they were betting against.

To add insult to injury, stocks in a short squeeze often trade on higher volume. This means that short sellers may have to, get this, chase the price higher to close their trades.

Ouch.

The result is a stock typically making an unusually fast move higher. And it’s these types of moves that generate oversized profits … IF you can spot the short squeeze before it happens.

So how do I find the short squeeze lying in wait? Just follow these simple steps.

How to Know When a Profitable Short Squeeze Is On

Step one: Filter the bi-weekly short interest data from the exchanges to identify stocks with “unusually” high short interest. What’s unusual? Well, my models search for short interest ratios (short interest divided by the average daily trading volume) above 6.0. You can use that number, too.

In addition, the model searches for increasing short interest, indicating that the shorts are adding to their bets against the stock.

Step two: Among these high short interest stocks, look for those in a strong technical uptrend. I look for stocks that are trading above their rising 50-day moving average. My models show that the odds of a stock moving higher double when the 50-day moving average is trending higher.

It’s this combination of high short interest (bearish sentiment) and bullish technical strength that creates a short squeeze situation.

Think about it: Being short a stock in these conditions is kind of like getting caught – squeezed – between two huge, speeding freight trains headed right for one another at 60 mph. Hairy place to be. Where we want to be is out of harm’s way and betting on the collision itself.

Step three: Identify the “trigger price” by analyzing recent price activity, support and resistance areas, and the potential for new highs. This price level is where the shorts are likely to throw in the towel and begin to cover their losing positions. This is also the tipping point where the stock begins its FAR move that garners big gains for us.

Here’s Where You Can See This in Action

Let’s look at how this extremely profitable phenomenon is playing out right now in Allegion Plc. (NYSE: ALLE), a commercial services and supplies company based in Ireland.

Step one: Short interest on Allegion has been sharply climbing since October. Initially, this bearishness was justified after the stock gapped lower on a poor earnings report. Now, however, the shorts are at a two-year high despite the stock recovering most of its post-earnings losses.

In fact, after a 5% increase in just the past two weeks, current short interest is nearly 5 million shares, giving us a short interest ratio of 6.9. That means there is almost seven days’ worth of average daily volume to be covered should the shorts get squeezed.

That’s plenty to fuel a short squeeze rally!

Short sellers

Step two: ALLE’s 50-day moving average just transitioned into a bullish pattern. The last time this happened was in September, after which the stock rallied from $81 to $90 in less than a month.

Step three: I’m setting the trigger price at $84. A break above $84, which happened late on Thursday, will set off a flurry of buying, as the shorts rush to cover their losses. This will be followed by a FAR move that I see reaching $88 in short order.

Bull's

How to Play the Allegion Short Squeeze

Buying the stock at current prices should net a tidy 5% gain over the next month. That’s certainly a solid short-term profit.

But I’m an options guy, so I prefer to buy the February $85 call, which can be had for around $2.00. A move to my target of $88 will net around a 100% return before the company’s earnings report in early February.

Watch the short interest closely on stocks you’re interested in. Like volatility, it can make your trading go FAR.

 

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The post Why Short Sellers Are Actually a Bull’s Best Friend appeared first on Money Morning – We Make Investing Profitable.

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