One of my favorite, most powerful tools that’s been at the heart of my trading for more than 20 years is short interest.
In fact, I love it so much, I’ve written about it before, showing how I use it to help pick the best stocks for my Seismic Profits Alertsubscribers.
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Today, though, I want to approach short interest a little differently, because it’s telling us something very important about this market that all traders need to know.
Why This Is Such a Key Piece of Information
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. 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.
The reason I like short interest is 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 a stock. This results in unusually strong buying volume that drives a stock price higher.
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Typically, a short squeeze is triggered when the stock rallies enough so that short sellers feel the pressure of margin calls against their accounts. Or it’s as simple as 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 chase the price higher to close their trades.
The result is a stock typically making an unusually fast move higher. And it’s these types of moves that generate oversized profits.
I like to look at short interest at the macro level, as well. That is, what is short interest among all stocks telling me about the market?
Well, the same principle applies. When the shorts are active, the market overall has plenty of “fuel” to power a short-squeeze rally.
The S&P 500 provides a perfect illustration of what I mean. The chart below shows the total number of shares shorted among all S&P 500 component stocks. Note that the spike in January 2016 coincided perfectly with the market bottom.
From that point on, it was off to the races for stocks, as the S&P 500 gained nearly 60% in just two years. And it’s clear that this rally was powered in part by the unwinding of short interest – the “squeeze” – as short interest went on an extended decline.
Fast-forward to today, and we see short interest is hovering near its lowest levels of the past four years. That tells me there’s little fuel left in the tank to support another short-squeeze rally.
And that’s an important takeaway for traders. You see, in a raging market – like what we’ve seen for most of the past two years – making money in stocks was straightforward: Buy nearly anything that was highly correlated with the market, and let the bull market just sweep it higher.
Traders call it the “rising tide lifting all boats.”
But now, the tide is out, and it’s not coming back anytime soon. Short interest is low, and there’s no sure thing anymore. Gone are the days of letting the market take the place of stock analysis.
Great News: This Is a Classic “Stock-Picker’s Market”
I love a stock-picker’s market, because it separates the wheat from the chaff. Rather than simply following stocks higher, this market puts a premium on digging for opportunities at the stock level. There is no low-hanging fruit. This market requires work.
Getting my hands dirty is what I’ve done for more than two decades, so this is my favorite type of market to trade. And as I said, short interest is one of my favorite tools.
So how do I find the short squeeze lying in wait? First, I identify stocks with short-interest ratios (short interest divided by the average daily trading volume) above 6.0. In addition, my model searches for increasing short interest, indicating that the shorts are adding to their bets against the stock.
Second, I focus on stocks in a strong technical uptrend, defined as those 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.
Putting those criteria together helps me hone in on the stocks that have the best chance to advance, even in today’s sketchy market. But the list right now is thin, underscoring the emphasis on stock picking in the current trading environment. In fact, just 14 stocks within the S&P 500 currently satisfy my criteria of high short interest and technical strength required for a bullish trade.
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