Stocks & Commodities V.

26:13 (64-68): Working Money: In Search Of The Next Big Game by Matt Blackman

Stocks go up when there are more buyers than sellers,

down when the opposite occurs and short-sellers are a
big part of the picture. But when a heavily shorted stock
rallies, it can provide those in the know with a powerful
trading strategy that works well in both good markets and
bad. Heres how it works.

trading, the stock gapped up, opening the next regular trading
day at $6.73 and zooming up to close at $7.46. Over the next
week it continued to rally to as high as $8.50.
The news was good, but it certainly wasnt that good. What
caused this explosive breakout? Hint: The stock had been
heavily shorted. But how do shorts, betting that the price will
drop, help catapult a stock into the stratosphere?

by Matt Blackman

DOUBLE-EDGED SHORT SWORD

fter the market closed on November 28, 2007, digital

video recorder manufacturer TiVo Inc. (TIVO) announced a loss for the fiscal third quarter that was less than
expected on a 14% rise in revenues. The stock had closed the
normal trading day at $5.98. But in after-hours and premarket

Short-selling is commonplace on US exchanges. The transaction is initiated by those who believe share prices will fall; they
sell the shares now and buy them back later at a price they are
betting will be lower. This is only possible if short-sellers are
first able to borrow the shares they wish to sell from their
broker. A transaction fee is charged by the lender of the shares.
Shorts target companies for a number of reasons, but they

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BRUCE WALDMAN

In Search Of
The Next Big Game

Stocks & Commodities V. 26:13 (64-68): Working Money: In Search Of The Next Big Game by Matt Blackman

TRADERS NOTEBOOK

do so with one purpose a belief that the stock price will drop.
But as history has proven time and again, the majority is
usually wrong at turning points, and as a group, shorts arent
any smarter than the rest of us. This means that when short
interest as a percentage of float is high (5% or greater) and the
stock changes direction due to an unexpected event, most
shorts end up on the wrong side of the trade. It also means they
will have to make a hasty exit or risk losing a bundle.
Here is an important point about shorting that exerts a
strong influence on participants: There is no limit to how far
up a stock can go in a rally. Just look at a stock like Google
(GOOG) that saw its stock price rise from its initial public
offering in August 2004 of $108 to more than $740 in
November 2007, which is more than a 700% gain. Risk is
limited to the amount invested.
However, this situation is reversed for the short-seller
the gain for a short is limited to 100%, and that is if the stock
goes to zero. But the real kicker is that a short position has
unlimited potential for loss. For example, a short position in
Google entered in 2004 would have been down 700% by
November 2007 if it had been unleveraged (no margin). A
position margined 50% would have been down 1,400%. An
initial position that cost $10,000 would have generated a loss
of $140,000. And the loss continues to compound in a rally.
This characteristic is a powerful motivator for shorts to
cover when they are proven wrong and one big reason why
most will charge for the exits if a loss looks imminent.

A NAKED SHORT?
As Warren Buffett once said, Its only when the tide goes out
that you discover whos been swimming naked. Shorting a
stock without buying an offsetting call as insurance (hedge)
is often referred to as a naked short position but is really a
hedged short.
A true naked short is somewhat more menacing, however.
According to the Securities and Exchange Commission (SEC),
a naked short sale occurs when the seller does not borrow or
arrange to borrow the securities in time to make delivery to the
buyer within the standard three-day settlement period. As a
result, the seller fails to deliver securities to the buyer when
delivery is due; this is known as a failure to deliver. While this
saves the usual transaction cost, the real benefit to practitioners
has far more ominous implications for the rest of us.
Bloomberg Television aired a 25-minute documentary in
March called Phantom Shares that is a must-see for anyone
who trades (or invests). The show opened a fascinating
window on the practice of naked shorting that has permeated
Wall Street for years.
Approximately $350 billion in shares traded daily and
were settled normally on US stock exchanges in 2006, according to the Depository Trust & Clearing Corp. (DTCC). Of
that, $6 billion worth had shares that failed to be delivered,
according to the documentary. Some of this shortfall was due
to a clerical error or the loss of share certificates, but naked
shorting is a notable culprit.
While naked shorting isnt illegal (unless fraud can be

WORKING-MONEY.COM

proven) and in fact occurs daily and is necessary to facilitate

the orderly flow of shares by market makers, the problem for
shareholders is that because no share certificates change
hands, the naked short-seller could sell millions of shares that
dont exist. In the worst-case scenario, the practice can
overwhelm buy orders and drive share price into the basement, much like the impact on a currency that is heavily
counterfeited.
How will you know if shares of the company you own are
being manipulated this way? There is no specific naked short
data to warn investors that their shares are at risk (with one
possible exception that we will discuss). The SEC officially
forbids naked short sales but puts the restrictions on brokers,
not short-sellers.
The SEC enacted a new regulation called Regulation
Short Sales (RegSHO) in 2005 that was supposed to address
the problem by requiring that companies with shares that
failed to deliver (FTD) be put on a threshold list. Once on
this list, shares for companies must be delivered within 13
trading days and restrictions are placed on further short
sales in that company.
That the practice continues indicates that there is a loophole. Until a recent rule change, shares naked shorted in
a company before it was put on the threshold list could
remain unsettled almost indefinitely. While that loophole
has been closed, another remains, and according to Tom
Ronk, CEO and founder of Buyins.net, that is the lack of
enforcement.
One only has to look at the unwitting poster child for naked
shorting that until recently topped the RegSHO threshold list.
Before Overstock.com (OSTK) was removed December 17, it
had been on the list for nearly two years (669 days) according
to Buyins.net, a service that tracks short data. On December
18, 2007, a total of 32 companies appeared on the list with
shares listed as FTD for 100 days or more.
At the top of that list was Medis Technologies (MDTL) with
FTD shares for 597 days, according to Buyins.net. This
situation clearly shows that the practice is still alive and well.
Think this is only a problem that affects cheap stocks?
Think again. A total of 168 companies had shares appear as
FTD on the RegSHO threshold list on December 19 with an
average selling price of $19.30. They include companies
Chipotle Mexican Grill (CMG) at $140.45, iShares S&P
National Municipal ETF (MUB) at $101.92, and iShares Tr
Biotech ETF (IBB) at $81.28.
The good news is that the furor surrounding short sales,
and resultant RegSHO, made more detailed short-sales data
readily available to the public. This makes it possible for
companies like Buyins.net to collect, collate, and publish

While finding short squeezes

isnt always easy, the effort has
the potential to produce some
handsome dividends.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 26:13 (64-68): Working Money: In Search Of The Next Big Game by Matt Blackman
TIVO - TIVO INC. (Daily)
Template: Standard
2006
Q2

comprehensive reports, and this

means that its now easier to
recognize potential short
squeezes. A short squeeze occurs when a companys shares
are heavily shorted, but then
some news or other event (like a
great earnings report) occurs that
causes massive share buying,
driving the stock price higher
and in the process putting shortsellers underwater. In effect, it
allows long positions to make
money at the shorts expense.
Here are some compelling
examples.

Q3

Period

Symbol: TIVO
Q4

2007
Q1

Q2

Q3

Symbol

Q4

Pennant pattern

Scale
2008
Q1

8.5
8.25
8
7.5
7.0
6.5

Squeeze trigger

6.0
5.5
Squeeze trigger

TIVO TAKEOFF

VMA 10

10-day volume moving average 4715K

One day before the stock gapped

up, 17.8% of the TIVO stock
float had been borrowed and
796K
18.7 M
sold by short-sellers (see Figure
1). This amounted to a total of
17.13 million shares worth
nearly $60 million on November 28, which meant that shorts
FIGURE 1: TIVO, DAILY. Daily chart of TIVO showing the green up arrow on November 29, the day Buyins.net issued the
had to buy this amount of stock news release announcing the stocks squeeze trigger price of $6.17 and heavy short position. The stock continued to rally
to exit their positions. But thanks for the next week before consolidating in a bullish pennant pattern over the next few days.
to a gap up the next day, the cost
to cover had jumped to nearly $80 million. By the close this SHORTS GET TASERED
amount was approaching $90 million. (Remember that shorts, Our next example of a short squeeze occurred in June 2007 as
especially those using margin, are now underwater many the market struggled with the subprime slime credit melt. On
times their initial investment.)
June 19, Buyins.net issued a news release announcing that stun
TIVO moved above its squeeze trigger price of $6.17 on gun manufacturer Taser International (TASR) had moved above
November 29. A squeeze trigger is the short-squeeze line in its squeeze trigger price of $12.40 per share, with 14.45 million
the sand that tells the market when the long-term average declared shares short. At the time short interest totaled a
short position starts to lose money. Technically, the squeeze whopping 26.9% of the float.
trigger is the volume-weighed moving average of the price at
As we see from Figure 2, the breakout was not nearly as
which shorts sold the stock. As the stock rallies back toward explosive as in Figure 1 the stock didnt gap up for three
this price, the greater the pressure on shorts to cover and the more days. But when it finally came, it gapped up $0.79 or
faster it rallies, the more powerful this motivating force. This 6.25%. Not a bad daily return.
is clearly evident in the gap and subsequent move in the price
What caused the gap? A search of the Taser website
of TIVO.
revealed that two product liability lawsuits against the comThere is little doubt that the $0.75 gap between the close pany had been dismissed on June 20 and 22. That may have
November 28 and next days open was the result of short- been part of it, but the real dynamic could be found in the fact
covering as shorts fought with buyers to get stock in overnight that the stock had moved above its squeeze trigger price of
trading. This short squeeze continued for the next six days $12.41. Once this line in the sand had been crossed, shorts
before TIVO entered a consolidation phase around $8.25 (see took it as a signal to cover. Few wanted to incur a loss.
Figure 1). Investors who owned the stock through this period
profited handsomely in a classic short squeeze.
FUELCELL: CUP & HANDLE SQUEEZE
So what happened to the short position next? As of Decem- Here is another example of the power of the short squeeze.
ber 20, short interest had grown to 17.94 million shares or In my December 12, 2007, Traders.com Advantage article
18.5% of the float, according to the latest data available from Supercharged FCEL Makes A Break For It, I wrote: As
Buyins.net. So it appears that if anything, shorts are stubborn. the news release issued on December 5 highlights, a total of
If TIVO remains strong, chances for another short squeeze 10,863,800 [FCEL shares] were sold short at an average
occurring are good.
volume weighted or squeeze trigger price of $9.292. This
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TRADERS NOTEBOOK

Stocks & Commodities V. 26:13 (64-68): Working Money: In Search Of The Next Big Game by Matt Blackman
WORKING-MONEY.COM

TASR - TASER INTERNATIONAL INC. (Daily)

Template: Standard

Period

Symbol: TASR

Symbol

Scale

2007

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

19
18
17
16
15
14.86
14
13
Squeeze trigger

12
11

June 19, 2007

10
9
8

VMA 10

10-day volume moving average

8111K

721K
18.7 M

FIGURE 2: TASER, DAILY. Daily chart of Taser International showing a squeeze trigger on June 19 followed by a gap up
on June 22 and a squeeze trigger price of $12.41. This tends to act as an area of major support as this chart demonstrates.

meant that at the time, short-sellers still needed to buy back

approximately $102,880,186 worth of shares to cover their
short positions, which represented 12.7 days of average
daily volume, according to Buyins.net. That kind of buying
will drive just about any stock significantly higher, which is
exactly what occurred over the next six days.
As we see from Figure 3 that is exactly what happened over
the next two weeks, with FCEL closing at $12.88 on December 20, up 35.3% from its December 5th closing price when
it broke above its squeeze trigger. But this chart also shows
how quickly short squeezes can run their course. By December 27, FCEL was back near $10.
In my experience, short-squeeze breakouts tend to last
anywhere from two weeks to three months when the fundamentals and market conditions support the rally. I have seen
some last longer than six months. However, this is not a longterm, buy & hold type strategy.
It is also best that besides supporting fundamentals, shortsqueeze targets also demonstrate supporting technicals
(trendline support and/or bullish chart pattern).

THE ART OF FINDING THE SHORT SQUEEZE

Shorts (and naked shorts) are an investing fact of life and
neither party is going away anytime soon. In fact, shorts got
a boost recently with a change in the uptick rule, which means
sellers can now sell a stock short while it is falling.
But this wont deter traders and investors who actively search

out short squeezes that have

found a way of making lemonade out of lemons. In fact, the
opposite is probably true the
more shorts in the market, the
greater the number of potential
short squeezes.
Rather than get caught in a
stock that has been driven lower
by shorts, patient traders bide
their time waiting for their chance
to pounce, and that is when the
stock starts to rally toward or
above its squeeze trigger.
Here are the steps to help find
short squeezes:
1 Look for stocks with a relatively high short interest as
a percentage of the float.
Five percent is only a suggested threshold.
2 Look for stocks that have
rallied and are approaching their squeeze trigger
(short squeeze threshold
level).

3 Look for fundamental strength or a positive corporate

development. A stock that has recently issued some
positive earnings news or an exciting new product
increases the probability for a strong rally.
4 Look for technical confirmation. Bullish reversal chart
patterns like an inverse head & shoulders, double or
triple bottom, cup & handle or strong continuation
patterns like bullish flags and pennant patterns greatly
increase the odds that it will rally. Consolidation patterns like a rounded bottom and areas of strong historical support are other positive patterns.
5 To enter the trade, you have a number of options that
include buying the stock outright or buying either an
in-the-money or out-of-the-money call (if you are into
options).
6 Always use a stop-loss. This will depend on the stock
in more expensive stocks, this can be a trailing 5%
stock but for more volatile inexpensive stocks, the
stop-loss might be 10% or higher. The goal is to not get
shaken out of your position by normal volatility. A stop
of 5% below the squeeze trigger is a good exit point.
Ignorance about short positions in the stocks you trade is
another example of how what you dont know about the

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Stocks & Commodities V. 26:13 (64-68): Working Money: In Search Of The Next Big Game by Matt Blackman

TRADERS NOTEBOOK

FCEL FUELCELL ENERGY INC. (Daily)

Template: Standard

Symbol: FCEL

Period

2006

Q4 Q1

Q2

Q3

Scale

Q4

Q1

Q2

Q3

Q4

15

market can hurt you. However,

once armed with the appropriate tools and resources, traders
can use big short positions to
their favor when the right conditions exist.
Pitfalls that catch uneducated
traders off-guard can become a
distinct benefit to the initiated
who know how to use them to
their advantage. Short squeezes
are a great example and while
finding them isnt always easy,
the effort has the potential to
produce some handsome dividends over a relatively short time.
Matt Blackman is the host of
TradeSystemGuru.com, a
website devoted to discovering
and better utilizing cuttingedge trading tools and winning
market strategies. He also publishes a free weekly stock market newsletter. He is a member
of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA).

Symbol

2007

14
13
12
11
10.33
Squeeze trigger

9
8
7

VMA 10

10-day volume moving average

6
4133K

282K
15.0 M

FIGURE 3: FCEL, DAILY. Daily chart showing the breakout following the December 5 squeeze trigger news release after
which the FCEL stock rallied more than 35%. A bullish scenario is further supported by a bullish cup & handle pattern that
began in the second quarter of 2006 and looks to still be in the process of forming.

SUGGESTED READING
Anatomy of a Short Squeeze, http://tradesystemguru.com/
content/view/131/9/
Phantom Shares video, http://tinyurl.com/yrbnn3
Coming Up Short On Share Lending, http://
www.buyins.net/articles/nakedshortarticle.pdf
Failure Is An Option: Impediments To Short Selling And
Options Prices, http://tinyurl.com/33w3oc
DTCC response to naked short selling claims, http://www.
dtcc.com/leadership/issues/nss/
SEC Amends Regulations To Curtail Naked Short Sales,
http://tinyurl.com/2gesd4
Fined By The NYSE Over Short-Sale Violations, http://

tinyurl.com/2v84jd
Overstock Shares Rise On Court Ruling In Broker Suit,
http://tinyurl.com/3drdba
Hedge Funds Founder Settle Short-Sale Probe, http://
tinyurl.com/2t3xzp
Naked Short Selling Explained, http://en.wikipedia.org/
wiki/Naked_shorting#External_links#External_links
Naked Short Victim Strikes Back, http://www.forbes.com/
business/2007/02/02/naked-short-suit-overstock-bizcx_lm_0202naked.html

This article and articles like it can be

found online at www.working-money.com.

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