Short Interest: The Best Bullish Indicator the Market Has to Offer

Short sellers are a bull’s best friend.

That statement is one of my 10 commandments of trading, but to many, it may appear contradictory.

Short selling is an investment strategy that bets on a decline in a security’s price. A trader opens a position by borrowing shares of stock from their broker and then selling them in the open market.

Before the short seller has to deliver to their buyer, they expect the shares to drop. Then, they can purchase them at a lower cost, keeping the difference and making a profit.

Put simply, short sellers are bearish. So how are they a bull’s best friend?

Case in point: GameStop Corp. (NYSE:GME). At the end of 2020, the company was virtually obsolete after 36 years of business. Who goes to a store to buy video games when you can just download them yourself – especially during a pandemic? GME was set to become the next Blockbuster as far as anyone was concerned.

Enter the Wall Street short sellers. Guys from hedge funds like Melvin Capital started selling tons of GME shares, betting that the stock would eventually go from under $20 to $0.00 – igniting the biggest short-squeeze rally I’ve ever seen in my 30-plus-year trading career.

In order for a short seller to make money, they need to buy back shares for less than they sold it for. But GME didn’t fall closer to $0.00. Thanks to subreddit WallStreetBets, retail investors everywhere started buying up shares of the electronic retailer, pushing the stock higher. So short sellers were forced to buy back their shares for more than what they sold it for…

A lot more.

And as these short sellers bought back their shares, it pushed the stock to incredible new heights.

In less than one month, GME shot from around $17 to $347 – a 1,941% increase that will go down in history as the perfect example that short sellers are, in fact, a bull’s best friend.

And get this: I called GME’s jump.And you could have too.

Twice a month, I analyze short interest data from each of the market’s stock exchanges. This scan hits more than 17,000 data points – and it’s able to show me a list of stocks with the highest short interest. Essentially, as I just showed you, this is a list of stocks getting ready to enter a potential short squeeze that would shoot the stock higher.

Two weeks before GME’s historic move, the gaming stock sat right smack-dab in the middle of my short interest list.

In order for a stock to become a short-squeeze candidate, it only has to meet three criteria:

  1. The stock has a short interest ratio of 6.0 or higher.A stock’s short interest ratio is simply the number of days it takes short sellers on average to cover their positions, or buy back their borrowed shares. GME’s was 6.3.
  2. The stock is trading above its 50-day moving average (MA).The 50-day MA is just a stock’s average price over the last 50 days of trading. If the stock is currently above that 50-day MA, then it’s a good sign that it’s about to jump.
  3. The stock’s 50-day MA is climbing higher itself.If the 50-day is trending higher, then it means the stock will likely continue its bullish run.

 

GME met all three of these criteria. But it’s important to realize that GME’s feeding frenzy is a bit of an outlier. But it wasn’t the first stock that benefited from a short squeeze, and it certainly won’t be the last. And while you may not be able to jump on another almost 2,000% profit, you can start to take consistent 10%-20% profits by playing future short squeezes – and together, a series of wins like that makes for one of the strongest portfolios you can build.

Back in 2004, I performed a short interest study that showed me short-squeeze candidates outperform the market by more than 2:1 with a success rate of nearly 90%. That means that nine out of 10 times, short squeezes have doubled the market’s performance.

Doubling the broader market’s returns is an incredible feat. And as long as a stock meets those three criteria, it could return 10%-20% in days… and even double your money over the following four to six months – making this short-squeeze indicator a trader and investor’s dream.

Sincerely,

Chris Johnson

Quantitative Specialist

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