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Why do good things happen to bad stocks?

I recall a particular situation several years ago on CROX. My due
diligence indicated that the equity was overpriced and was due for a
pullback. Sales were declining, the fundamentals were terrible, but
the stock was rising. It was clear to me that the stock was going to
trade lower.

I placed my bearish options trade and watched the stock continue to
rise. I adjusted my trade to give it more time to work. The
adjustment that I did gave me more time, but it also increased my risk
(because I did a roll and widen adjustment.) I was convicted in my
belief that the stock was overpriced and was prime for a bearish move.

Despite my strong and well-found opinion, the stock continued to move
higher and higher. Finally, I gave up and closed the trade for a
loss.

The lesson that I learned was: good things happen to bad stocks.

I wasn’t the only one who saw the writing on the wall. Other traders
came up with exactly the same sentiment. Those traders were also
bearish, but chose a different strategy. Those traders were selling
the stock short.

Short selling involves borrowing the stock and then selling it. (Yes,
you can sell something that you don’t own.) Their hope is that they
can sell the stock at a high price and then buy it back at a lower
price later. (Short selling is an advanced strategy and has unlimited
risk. Traders need to be very careful with this strategy.)

You can find out information about short sales for free from NASDAQ
(www.nasdaq.com.) This information is updated twice per month. The
information provided includes:

  • Short Interest – number of shares sold short
  • Avg Daily Share Volume – average number of share sold per day
  • Days to Cover – Short Interest divided by Avg Daily Share Volume

The Short Interest alone does not tell you much. Is 1 million a lot
of short interest? Is 10 million? You need to have something to
compare it to. That is why the Avg Daily Share Volume is shown. It’s
there to assess the significance of the Short Interest.

The measure of Days to Cover literally answers the question: “How
many days would it take if all the short sellers decided to cover
their short positions and 100% of all the trading was just the short
sellers buying to cover?” In reality that would never happen. There
would be other traders buying and selling, as normal. The Days to
Cover is just a number to put things into perspective.

What is a high Days to Cover? It’s all relative. It is different for
every stock. Generally speaking, less than 2 days is small and would
indicate that there are not a lot of bears. However, some equities
that are trading very bullishly run with typical Days to Cover of 6 to
10 days. It just depends.

It’s also important to realize that there are two inputs to the Days
to Cover calculation. There is the number of short shares, but also
volume. If the volume were to change dramatically, it would affect
the Days to Cover calculation. With high volume, the Days to Cover
would drop and with low volume, the Days to Cover would rise. The
trader must look at all of the numbers to get a sense of what is going
on.

Another valuable measure is the Short Float. That is the Short
Interest divided by the total float (number of shares available for
trading.)

Why is this short information important? It is important because it
helps explain: why good things a happen to bad stocks?

It may seem counterintuitive, but short sellers can actually make a
stock go higher.

What causes a stock’s price to move? It is supply and demand. The
more people buy, the higher the price. And the more people sell, the
lower the price. It’s economics 101.

Let me explain a scenario to demonstrate the point.

Let’s assume that a bunch of traders develop a bearish sentiment on
XYZ stock. They start building bearish positions by selling the stock
short. Eventually, the stock falls, lower and lower. At a certain
point, some of the short sellers decide that it is time to take
profits. To cover their short positions, they buy stock. This buying
action is seen as bullish transaction and when enough of it occurs, it
will cause the stock to stop dropping. Now, other short sellers will
see this action and decide that they should take profits, too. With
this buying, the stock may actually start to rise. Still more short
sellers realize that they are missing out on the maximum profit and
they decide to cover their shorts. Now the stock starts to show
bullish signals. As it rises past the point where some short sellers
had originally shorted the stock, those traders are looking at a loss.
What do they do? They cover their position to minimize the pain.
Finally, other short sellers are watching the stock as it looks like
it’s about to go into outer space. The fear of “unlimited risk”
kicks-in and on the verge of shear panic, they doing anything they can
to get out of those short positions. And, this makes the stock go
even higher.

This phenomenon is known as “Short Squeeze.” And it happens a lot.
And it explains why good things happen to bad stocks.

Eventually, the bad stock should drop to seek its proper price. But,
the question is: can the short sellers have the tenacity to live
through that pain and also risk a margin call while the stock moves
higher.

I have been burnt by the short squeeze in the past. And like a hot
stove, I avoid touching trades that could burn me again.

Is there a way to use the short squeeze to your advantage? Maybe.
But I think it’s more important that traders are aware of this
phenomenon and factor it into their trading plans. For me, I avoid
placing bearish trades.

Eric Hale
OptionsANIMAL Instructor

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