Lately, the media has been talking up a storm about stocks with a high short interest proposing hedge funds are in trouble and need to cover. I find this a bit far from reality since most funds use capital and derivatives more efficiently than the average person thinks.
They, the media, or the so called professional being interviewed, seem to think any stock with a relatively high short interest and a trading day with a high positive net change is a short squeeze. Sometimes this is the case, but not always. Especially for stocks that are optionable.
You see, if a market participant is short an optionable stock and the stock starts to rally, to hedge themselves or, get delta neutral the participant can purchase an option instead of covering the stock in the open market. In doing so, the market participant does not add fuel to the current rally of their short position. Therefore, they can still hold the stock short and not lose any capital.
The theory of the media’s short covering rallies can be valid if the security in question is not optionable. In this situation, the hedge fund does not have derivatives to mitigate risk and to stop the trade from depreciating in value the fund will need to cover the stock in the open market – adding fuel to the rally in question.
Unfortunately, the stocks they were talking about were optionable so I would be suspect about calling that particular rally a short squeeze.
If I were to play the short interest / short squeeze trading game for either a daytrade or swing trade before I can make an investment decision I would need to the following data points increase the probability of a making a wise decision.
1st Gather the data for stocks with the highest short interest and days to cover ratios
2nd Filter out the stocks that are not optionable (this increases transparency)
3rd Look at the largest holders of the each stock and determine
Are solid mutual funds with deep pockets and good returns on the year?
Are the large holders of the stocks in question individuals or other hedge funds?
Take care and happy trading.
Mike Matousek, CMT
Portfolio Manager, ETF Updater
http://ETFUpdater.com
ETF Swing Trading and Day Trading 