What a wild week of trading it’s been and it’s only Wednesday…
Stocks were on the brink of collapse on Monday….
the plunge protection team jumped in and said that they are ready to facilitate this market and cut interest rates if need be…
Now, I’m not a big macro guy. I stick to trading catalyst driven momentum stocks based on a couple simple chart patterns and my horizon line.
However, I do follow the Russell 2000 carefully.
If you don’t know what that is, it’s an index of 2000 small-cap stocks… the type of stocks I primarily trade. I also use the Russell to gauge investor sentiment.
For example, I alerted Freedom Trader clients to my chart on the IWM yesterday, the ETF that tracks the Rusell 2000. And here’s what I wrote to them yesterday:
(Not a bad call yesterday, let’s see if it sticks)
That said, I think we’re in for an exciting summer of trading. Trading volume and volatility tend to decline during the summer historically.
However, small and micro-cap stocks tend to get wild when the rest of the market gets quiet…
I’m not kidding. And I know which stocks will be the biggest winners.
No, I don’t have a crystal ball of any sorts… but I do know the characteristics of these stocks, and I believe its worth it for you to learn them too.
Shorting Stocks Can Be Dangerous
You’ve probably heard me mention that I focus on chart patterns when I’m trading…
… but just because I focus on chart patterns and price action, that doesn’t mean I completely ignore the fundamentals.
You see, with momentum stocks… the catalyst matters, as well as identifying areas of value. Not only do patterns, value, and catalysts matter… but the structure of a stock matters too.
More specifically, I’m talking about the short interest.
If you don’t know, there is a specific amount of shares available to trade out there, and that’s known as shares floating.
Included in the floating shares is the amount of shares short (this information is crucial, and it’s helped me spot some winning trades) – more on why this matters later.
Now, if you don’t know, when traders short a stock… they’re betting against it. In other words, they want the stock to go down.
For some reason, traders love to short momentum stocks… and generally it’s for no good reason. They just think the stock is “up too much” and it has to pull in…
… and that’s just the wrong mindset to have.
Short Sellers Can Get Hurt in Momentum Stocks
With momentum stocks (stocks that could move a lot… very fast)… and shorting this type of stock is very dangerous.
You see, traders who are short a stock don’t have defined risk.
Well, do we really know where a stock could go?
For example, check out this daily chart in Tilray (TLRY).
Well, last year this was one of the hottest initial public offerings (IPOs) at the time.
I don’t think anyone out there thought this stock could run from around $20 to $300 in just over a month.
Those who were short took it on the chin… heck, some traders might have even blown up their account betting against this stock.
Now, this actually happens very often… maybe not of the same magnitude… but we do see crazy moves like this… and it’s what’s known as a short squeeze… and you never want to be caught in those.
For example, look at this trader who shorted KaloBios (KBIO) back in 2015… thinking the stock would pull back and he’d make 2 points… and headed to bed with $37K in his E*Trade account…
… only to wake up stuck in a short squeeze, as the stock ran up about 800%… thereafter, he owed E*Trade over $100K.
That said, shorting momentum stocks can be dangerous… and I like to be long stocks that look like they can squeeze shorts.
Short Interest Explained
Before we go over the mechanics of a short squeeze, you’ll need to understand the short interest.
Basically, short interest is the number of shares that have been sold short… but have not been closed out yet. In other words, traders still have an open short position in the stock.
Now, generally, we look at this in percentage terms.
When short interest is quoted in percentage terms, you’re simply dividing the number of shares short by the number of shares floating (the number of shares available for us to trade).
Don’t worry about having to calculate that… your brokerage platform should have that data readily available… if they don’t there are free tools like Morningstar and Finviz that provide short interest data.
The higher the short interest… the better, especially when you have positive catalysts, identify an area of value and bullish chart pattern.
In general, when a stock has a short interest greater than 20%… the stock is ripe for a short squeeze.
Mechanics of a Short Squeeze
Now, a short squeeze occurs when a stock spikes and forces short sellers to close their position.
The run up in the stock could be caused by a number of factors… ranging from a technical break out or a positive catalyst.
When traders short a stock, they have to borrow shares from their broker to sell it… because they’re selling something they don’t own… and at some point they have to buy back those shares short in order to cover their position.
Now, when a stock has a strong run up… these shorts scramble to close out their position to try to minimize losses… in turn, this increases the demand and decreases the supply.
What happens when there is more demand than supply?
Well, the stock goes up…
… if the stock continues to run higher… more shorts are forced to close out their positions because they simply can’t take the pain.
In turn, this can cause the stock to rocket even higher.
You’re probably wondering, “Well, Jason… I get it… shorting stocks are dangerous, but how can I make money off of this?”
Let me show you.
Short Squeeze Case Study
Now, I was actually keeping an eye on Veritone (VERI) a few weeks ago. This stock was up 15% after it reported strong earnings.
Additionally, there was a bullish chart pattern forming, and I was able to identify an area of value.
Not only that… the stock had a high short interest.
Check out this screenshot of VERI’s stats on Finviz. The stock had a short interest of more than 20%!
With so many bullish signals… I figured the shorts could get squeezed… and I let clients know about the trade idea.
Here’s a look at what the stock did the same day I bought it…
You see, there was little supply in the stock… with only around 14M shares available to trade… you might think that’s a lot…
but when you compare that to large caps like Facebook (FB), which as over 2B shares available to trade… 14M is nothing… and it doesn’t take a whole lot of volume to cause the stock to explode.
If you notice, once VERI broke above the blue horizontal line (an area of value)… the stock just rocketed higher.
Well, you have technical traders who bought the break out above $7 (I was one of those buyers)… which increased the demand for the stock.
Then, at some point the shorts (who were over 20% of the shares floating) probably covered their shares… which increased the demand for the stock even further (remember shorts have to buy shares to cover their positions and prevent any further losses).
Consequently, the buying pressure from both the shorts and momentum buyers caused the stock to spike.
Well, just a few hours after I bought… I locked in $9,300 in trading profits.
You can either be a trader who gets squeezed… or a trader who buys the stock and “squeezes” the shorts… I prefer the latter.
Now, if you want to learn more about how I’m able to spot trades like these… or just need someone to walk you through how momentum stocks trade, click here to get started.