Masters Series: Short-Sellers Beware: This Could Happen to You
Editor's note: In yesterday's Masters Series, Stansberry & Associates trading expert Jeff Clark shared the simple three-part test he uses to identify stocks that make promising short-sale candidates...
Although many people are reluctant to try short-selling – an investment that profits as a stock price falls – it's a valuable technique in most investors' "tool box."
In today's essay – published in the May 10 edition of S&A's free e-letter Growth Stock Wire – Jeff highlights one pitfall that can undermine a short position... even one placed on a vulnerable stock. And more important, he tells you how to avoid it…
Short-Sellers Beware: This Could Happen to You
By Jeff Clark, editor, S&A Short Report
As any elementary school nerd or frat-house pledge will tell you, there are few things in life that are more painful than having someone grab your shorts from behind and yank them as far up your backside as possible.
In the world of YouTube pranks, it's called a "wedgie." In the stock market, we call it a short squeeze. And – like a wedgie – if you're on the wrong side of one, it hurts...
A short squeeze happens when a heavily shorted stock rockets higher overnight – usually as the result of a favorable news announcement or corporate press release. The gains are unusually large as traders rush to buy as much as possible and press the share price high enough to force short-sellers to capitulate, buy back their shares, and push the stock even higher.
In the long run, stocks with a large short interest – say, 30% of the outstanding float or more – run into trouble over time. The best short-sellers – like Jim Chanos (who famously shorted Enron before the company's demise) and David Einhorn (who made a fortune shorting Lehman Brothers) – perform extensive research... and they're right about their calls much more often than they're wrong.
But in the short term, stocks with a large short interest can see tremendous moves higher.
Here's a look at a few stocks that got squeezed yesterday...
Electric carmaker Tesla Motors (TSLA) popped 24% higher yesterday on the heels of a stronger-than-expected earnings report. Nearly 50% of TSLA shares are sold short. The stock has doubled in the past five months...
Coffee company Green Mountain Coffee (GMCR) also surged higher after reporting earnings yesterday. Thirty-eight percent of the stock is sold short. That helped propel a 28% gain yesterday...
Thirty-six percent of bookseller Barnes & Noble (BKS) shares are sold short. Short-sellers suffered an "atomic wedgie" yesterday following reports that Microsoft would pay $1 billion for the company's Nook division. BKS shares spiked 24% on the news. (Editor's note: Since Jeff originally published this essay, BKS shares have fallen back to around $20.)
As I said earlier, stocks with more than 30% short interest often turn out to be excellent longer-term short sales. But those are the exact same stocks that are most prone to getting squeezed in the short term. It's often a good idea for traders to watch these stocks. When you see a short squeeze, let it run its course, and then enter a short position once the stock starts to trend lower.
Best regards and good trading,
Jeff Clark
Editor's note: As we said, learning how to identify overvalued stocks primed for a fall... and trading the situation... is a valuable tool for investors to learn. And S&A Short Report editor Jeff Clark is among the most successful traders at it.
Over his 20-plus-year career, Jeff has developed several other trading strategies for making money in any market. Recently, he showed readers a way to successfully trade the gold markets… whether the price goes up or down. To learn how to make five to 10 times your money in gold – without relying on stocks or bullion – click here.