by Andrew Horowitz

Short Squeezes—what are they and how can they help your portfolio?  That's what we'll discuss in this episode of the Winning Investor.

Let's start with a definition of this unusual topic and learn how we can put it to work for us.

What is a Short-Squeeze?

A Short-Squeeze occurs when short-sellers in a stock are forced to buy-back their positions quickly, usually at about the same time or price level, which can result in a powerful upward movement in the price of the stock.

Let's look at it from the other perspective since many investors will never short-sell a stock in their entire investing lives.

When you purchase shares of a stock, you expect to sell your shares later at a profit.  Traders want to sell the shares quicker than investors, who may hold a stock position in their portfolio for months or even years.  

However, if the price of the stock declines sharply, or something changes in the fundamental analysis picture which was the reason investors bought the stock in the first place, then those investors decide to sell their shares at a financial loss and that's never a pleasant event.  In fact, many investors hold on to losing positions far too long and sell only when the pain of losing money is too great.  

If a negative event happens, it can force a lot of investors to sell their positions very quickly, which can result in a large percentage move to the downside in the stock's price.

As long as we understand this logic of investors suddenly selling their positions at roughly the same time, we can then use the same logic in reverse to describe what happens when short-sellers rush to buy-back their short positions quickly.

Usually, you don't see investors sell stocks short, but instead you see traders short-selling or else hedging their positions by shorting shares of a weakly performing stock.  

When a trader short-sells a stock, he or she expects the price to decline in the future and thus will buy-back the borrowed or shorted shares at a future date, hopefully when the share price has declined.

If instead, the share price rises, the trader will be forced to buy-back the shorted shares at a financial loss.

As you can probably guess, when a lot of traders rush to cover or buy-back their short positions at the same time, this can cause an influx of buy orders into the market which helps propel the price of the stock higher. This is what’s known as a short-squeeze.

Short-squeezes that result from lots of short-sellers covering their positions can be beneficial to investors as it often creates a rally or rise in the price of the stock.  That's good for you, the investor!

How to Use Short-Squeezes to Make Money?

So how might we use this information to our advantage?

While we can't exactly predict when a short squeeze is about to occur, we can compare reported short interest for stocks as reported in your favorite financial website such as Yahoo Finance or Google Finance.

You may have to dig a little, but you should be able to find a section or text called "Short Interest," which tells you how many shares are reported as being sold short for that particular stock.

Using that, you can calculate the Short-Interest Ratio, which would be the number or shares sold short divided by the number of shares outstanding.  Most websites that give you the Short Interest will also publish the Short-Interest Ratio nearby.

For example, at this moment, Google (GOOG) reports 325 million shares outstanding and has reported Short-Interest or shares sold short at 3.61 million shares.  That gives us a Short-Interest Ratio of 1.3%.  That's low.  In other words, Google would be less likely than another stock with a higher Short-Interest Ratio to experience a sudden Short-Squeeze which would benefit investors.

However, there's a Catch-22 for investors. While investors generally benefit from short-squeezes, an investor shouldn't buy a stock just because it has a high Short-Interest Ratio.  Stocks with high Short-Interest Ratios tend to be those that are financially weak or otherwise unfavorable to investors for some reason.  There's usually a reason a stock attracts a lot of short-sellers who hope to profit from a decline in its share price.

But as long as you know what a Short-Squeeze is and how to find a stock's Short-Interest and Short-Interest Ratio, you can use this information to your advantage.

If you're looking at two identical stocks from a fundamental and technical analysis standpoint, maybe you choose the stock that has the higher short-interest ratio... again, if all other factors are equal!

And of course consider picking up a copy of my latest book The Winning Investor's Guide to Making Money in Any Market is available at Amazon and other fine booksellers. And in print and digital versions, too! 

Want to become a Winning Investor? Then be sure to get your copy today - The Winning Investor's Guide to Making Money in Any Market.