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Profit from Short-Squeeze Candidates |
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Published:
November 5, 2007
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 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?
The Workings of a Short Squeeze
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.
Straying from the Herd
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.
Nathan Slaughter, editor of
StreetAuthority's premium value
investing newsletter
Half-Priced
Stocks, set out in search of viable
short-squeeze candidates -- more
"powder kegs" -- in a recent issue.
Nathan evaluated the short interest,
short interest ratios, fundamentals,
and valuations of a multitude of
stocks, and found nine exciting
companies that could be the next to
blow, thanks to a short squeeze. He
also provided an in-depth analysis
of two of his favorite candidates --
including one with a price
appreciation potential of +32%. To
see Nathan's list and to learn more
about the
Half-Priced Stocks
newsletter, please
visit this link. |
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