Usually buying stock at its 52 week high is a bad idea, but it does not have to be. The fundamental tenant of investing has always been buy low and sell high, but it can be profitable to buy a stock at its 52 week peak contrary to popular belief when the short sellers are in trouble. Short sellers are more like gamblers than investors. They bet on a company’s stock price to go down rather than up. They are kind of like a gambler betting on the “Don’t Pass” line at craps (a very unpopular bet against the shooter). It goes against the grain of conventional investing and bets against the market. Short sellers borrow shares of a stock from the market and sell them in hopes that the share price will decrease in the short term. Then, they buy the shares back in the open market at the new lower price in order to give the shares back to the “person” who lent them to the investor in the first place. Clear as mud, right?
When an unusually large portion of a company’s stock is sold short, or shorted, the stock price can still start to rise. When the rise happens, investors who are short (hoping that the price will fall) will get squeezed when they have to buy the shares back at a higher price than they sold them for. Short sellers will have to start buying the stock back at some point while it is rising or risk losing their shirts as their losses mount. The short sellers’ extra buying will continue to make the share price increase. A short squeeze is a classic example of supply and demand in the market. Investors get squeezed when a rapid increase in the price of a stock occurs because there is a lack of supply and an excess of demand for the stock.
Why do short sellers have to buy back their shares? There are many reasons. The best reason for long investors is when short sellers have sold on margin, or borrowed the stocks without putting up much cash. As the stock price climbs, the equity in their accounts often puts them below their broker’s margin requirements. So, they must cover their shorts. Brokers who lent the shares in the first place can recall the stock if their clients want to sell them for real. This is the essence of a short squeeze and regular long investors, who hope that the price will rise, can profit from the short squeeze if they can recognize it and act fast.
Short squeezes can be a predictor for a stock’s rise. Look for:
- High levels of short interest in a stock
- A stock getting a new rise (from a positive news story, new 52 week high, above the 200 day moving average, etc.)
- A large number of days it will take to cover the shorts
Take the number of shares in a company that are short and divide by the average daily trading volume. That will give you the number of days of buying that short sellers will have to endure to get out of their positions. The longer it takes them to get out may equal even more profits and new highs for the long investor.
Netflix (Stock Symbol: NFLX), the online movie rental business, currently 32% of its outstanding shares have been shorted or 22.15 million shares. The average daily volume for the stock is 1.3 million shares. If the stock price started to creep up and short sellers had to buy shares, it could take them approximately 17 days of buying to liquidate their positions. My favorite place to find this specific information is Yahoo Finance, in a company’s key statistics page.
When you buy a stock there is a finite downside. Your investment can only fall all the way to zero, wiping out only the money you invested up to that point. The same is not true for a short seller. When you short a stock, there is an infinite amount a stock can move up on the other hand. If a short seller is not careful, they could be out many times the amount of their original investment.