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Markets Feeling Short Squeeze

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An important sign of a true buying climax will be when the short interest hits new lows.

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I'm going to depart from my traditional options education today and provide more of a market observation. With today's market action I believe that we are seeing signs of total capitulation -- both by the shorts (through a short squeeze) and the fund managers who have too much cash sitting on the sidelines and have been praying for any decent pullback so they could get in. They are just plain throwing in the towel.

What is a short squeeze? Forgive me if you know this already but for those who don't, I'd like to explain what short selling is and why it's often a contrarian indicator.

Hedge funds that believe a stock is going down will borrow that stock (often from insurance companies and pension funds) and sell at the market. They will borrow the stock for a fixed period of time and will pay the lender a small fee. At the end of that time the stock must be returned to the lender -- bought back, in other words -- regardless of where the stock is trading. So, if I borrow IBM (NYSE:IBM) and sell it at $200, I have to return that stock even if I have to buy IBM back at $300. Needless to say, a short seller gets very nervous when the market just won't go down.

The amount of stock that has been borrowed and sold short is called the short interest and is public information. A very good site for quickly looking up short interest is the aptly named www.shortsqueeze.com. This site has a lot of proprietary data, but the free stuff is well worth looking at. You can see how many shares have been sold short, what percentage of all shares outstanding (known as the float) has been sold short, and how many days to cover it would take to get the shares back. (Days to cover means they take the average daily volume and extrapolate out how many days of trading it would take to buy back the short stock if all trading during that time was simply short covering.)

Why is this contrarian? Wouldn't you say a stock with a huge short interest shows a great deal of bearish sentiment? Yes, but…. those shares have to be bought back! The greater the percentage of the float that has been sold short, the more days it takes to cover those positions. And this adds up to inherent, must-be buyers. When the short sellers are being forced out of their positions by an ever-rising market, we call that a short squeeze. And few things take a stock more explosively higher than a true short squeeze. And I think we are seeing one now. This is even close to being the mother of all short squeezes. I think a real sign of a buying climax will be when most short sellers have indeed capitulated and short interest goes way down.

While I am not going to stand here and call the market top (full disclosure: I never thought we'd get this high), I will say that an important sign of a true buying climax will be when the short interest hits new lows.

Let's end with some options: If you want to take a bearish view, then buy a put spread or sell a call spread. Don't put yourself in a position to get squeezed!

This article by Randall Liss was originally published on See It Market.
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