There are very few guarantees when it comes to stock
investing. The ever-changing nature of the stock market can make
speaking in absolutes a fool's errand.
However, stock market behavior does repeat itself enough to
create some high-probability setups. Recognizing these setups is
one of the ways professional investors differentiate themselves
-- along with the patience to wait for these setups to occur
before entering positions.
#-ad_banner-#One of my favorites among these setups is
"fading," or going against, extreme market moves. This can be
done with indicators such as the relative strength index (RSI)
and Bollinger bands where extreme readings often signal a change
in trend. My favorite "fade" move is buying the most heavily
shorted stocks on the market.
These stocks are generally hated by most investors and often
have terrible fundamentals that support the heavy short
positions. However, not only do many heavily shorted companies
possess the potential for a explosive upward move due to a short
squeeze, they often outperform the market.
A Goldman Sachs research report last October titled "Investors
Focused on the Results of High Short Interest Stocks" found that
stocks with high short interest were most likely to outperform
during the quarter. The theory behind this is that a high short
interest indicates everyone has already sold or shorted shares.
If this is the case, the stock is at its low and has nowhere left
to go but higher.
Any good news about the company will trigger buying, which in
turn attracts more buyers, sending the stock higher. This upward
movement, in turn, forces the shorts to cover (meaning they buy
back the shorted shares), adding even more fuel to the upward
When dealing with extreme short interest, I like to take this
theory one step further -- by finding a stock that is dropping in
price along with high short interest. As soon as the stock posts
a positive close, I enter a long position with a pre-determined
number of shares. While this method may miss the aggressive first
move in a short squeeze, the reduced risk is well worth the cost
of missing a random short squeeze.
Under these criteria, the most shorted stock in the S&P
Cliffs Natural Resources (NYSE:
. Readers of Dave Forest's
Scarcity & Real Wealth
will recognize this firm's strong investment potential -- but
right now, a weak commodity market has weighed heavily on the
Cliffs Natural Resources is an iron ore miner with a market
cap of $2.9 billion. Shares are down over 20% this year due to a
lull in iron ore prices and a drop-off in demand from China. In
addition, a proxy battle is taking place between Casablanca
Capital, a hedge fund that owns a little over 5% of CLF, and the
company's board of directors.
Casablanca wants to spin off its Bloom Lake project in Canada
and its other international assets into a separate company called
Cliff's International. Casablanca asserts this move would enable
the company to thrive by turning the U.S.-based assets into an
MLP (master limited partnership) capable of doubling its current
CLF has a short utilization rate (the proportion of shares
available to borrow that are actually being used to short the
stock) of 72.6%. The higher the short utilization rate, the more
short demand there is for a stock. Compare that with the next
highest short utilization rate of 55.3% of
Joy Global (NYSE:
Shares hit a low in the $18 range March 10. Since this time,
price has bounced into the $19 area. Investors who followed the
idea of buying on the first up day in a heavily shorted stock
would be solidly profitable right now.
Risks to Consider:
Buying heavily shorted stocks, even after a positive close,
remains very risky. Remember the shares are shorted for a reason
and this reason may be very substantial. Although the statistics
are positive for buying shares with high short interest, it's
important to note that these numbers are based on a series of
trades. Any single trade may or may not perform as expected.
Always use stop-loss orders and diversify when investing.
Action to Take -->
I am expecting the high short interest to continue to push shares
higher in this natural resource company. If you don't already own
shares of CLF, buying a breakout above $19.50 with a nine-month
target of $24 makes investment sense right now. Investors with
greater risk tolerance can buy now in the $19 area, with stops at
$17.50 for both entry levels.
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