In Search of Next big game

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

Copyright (c) Technical Analysis Inc.

A

trading, the stock gapped up, opening the next regular tradingday at $6.73 and zooming up to close at $7.46. Over the nextweek 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 beenheavily shorted. But how do shorts, betting that the price willdrop, help catapult a stock into the stratosphere?

DOUBLE-EDGED SHORT SWORDShort-selling is commonplace on US exchanges. The transac-tion is initiated by those who believe share prices will fall; theysell the shares now and buy them back later at a price they arebetting will be lower. This is only possible if short-sellers arefirst able to borrow the shares they wish to sell from theirbroker. A transaction fee is charged by the lender of the shares.Shorts target companies for a number of reasons, but they

by Matt Blackman

fter the market closed on November 28, 2007, digitalvideo recorder manufacturer TiVo Inc. (TIVO) an-

In Search Of

Stocks go up when there are more buyers than sellers,down when the opposite occurs and short-sellers are abig part of the picture. But when a heavily shorted stockrallies, it can provide those in the know with a powerfultrading strategy that works well in both good markets andbad. Heres how it works.

nounced a loss for the fiscal third quarter that was less thanexpected on a 14% rise in revenues. The stock had closed thenormal trading day at $5.98. But in after-hours and premarket

The Next Big GameBR

UCE

WAL

DMAN



do so with one purpose a belief that the stock price will drop.But as history has proven time and again, the majority isusually wrong at turning points, and as a group, shorts arentany smarter than the rest of us. This means that when shortinterest as a percentage of float is high (5% or greater) and thestock changes direction due to an unexpected event, mostshorts end up on the wrong side of the trade. It also means theywill 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 farup a stock can go in a rally. Just look at a stock like Google(GOOG) that saw its stock price rise from its initial publicoffering in August 2004 of $108 to more than $740 inNovember 2007, which is more than a 700% gain. Risk islimited 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 stockgoes to zero. But the real kicker is that a short position hasunlimited potential for loss. For example, a short position inGoogle entered in 2004 would have been down 700% byNovember 2007 if it had been unleveraged (no margin). Aposition margined 50% would have been down 1,400%. Aninitial position that cost $10,000 would have generated a lossof $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 whymost will charge for the exits if a loss looks imminent.

A NAKED SHORT?As Warren Buffett once said, Its only when the tide goes outthat you discover whos been swimming naked. Shorting astock without buying an offsetting call as insurance (hedge)is often referred to as a naked short position but is really ahedged 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 orarrange to borrow the securities in time to make delivery to thebuyer within the standard three-day settlement period. As aresult, the seller fails to deliver securities to the buyer whendelivery is due; this is known as a failure to deliver. While thissaves the usual transaction cost, the real benefit to practitionershas 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 anyonewho trades (or invests). The show opened a fascinatingwindow on the practice of naked shorting that has permeatedWall Street for years.Approximately $350 billion in shares traded daily and

were settled normally on US stock exchanges in 2006, ac-cording to the Depository Trust & Clearing Corp. (DTCC). Ofthat, $6 billion worth had shares that failed to be delivered,according to the documentary. Some of this shortfall was dueto a clerical error or the loss of share certificates, but nakedshorting is a notable culprit.While naked shorting isnt illegal (unless fraud can be

proven) and in fact occurs daily and is necessary to facilitatethe orderly flow of shares by market makers, the problem forshareholders is that because no share certificates changehands, the naked short-seller could sell millions of shares thatdont exist. In the worst-case scenario, the practice canoverwhelm buy orders and drive share price into the base-ment, much like the impact on a currency that is heavilycounterfeited.How will you know if shares of the company you own are

being manipulated this way? There is no specific naked shortdata to warn investors that their shares are at risk (with onepossible exception that we will discuss). The SEC officiallyforbids 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 addressthe problem by requiring that companies with shares thatfailed to deliver (FTD) be put on a threshold list. Once onthis list, shares for companies must be delivered within 13trading days and restrictions are placed on further shortsales in that company.That the practice continues indicates that there is a loop-

hole. Until a recent rule change, shares naked shorted ina company before it was put on the threshold list couldremain unsettled almost indefinitely. While that loopholehas been closed, another remains, and according to TomRonk, CEO and founder of Buyins.net, that is the lack ofenforcement.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, ithad been on the list for nearly two years (669 days) accordingto Buyins.net, a service that tracks short data. On December18, 2007, a total of 32 companies appeared on the list withshares 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. Thissituation 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 asFTD on the RegSHO threshold list on December 19 with anaverage selling price of $19.30. They include companiesChipotle Mexican Grill (CMG) at $140.45, iShares S&PNational Municipal ETF (MUB) at $101.92, and iShares TrBiotech ETF (IBB) at $81.28.The good news is that the furor surrounding short sales,

and resultant RegSHO, made more detailed short-sales datareadily available to the public. This makes it possible forcompanies like Buyins.net to collect, collate, and publish

While finding short squeezesisnt always easy, the effort hasthe potential to produce somehandsome dividends.

TRADERS NOTEBOOK WORKING-MONEY.COM



comprehensive reports, and thismeans that its now easier torecognize potential shortsqueezes. A short squeeze oc-curs when a companys sharesare heavily shorted, but thensome news or other event (like agreat earnings report) occurs thatcauses massive share buying,driving the stock price higherand in the process putting short-sellers underwater. In effect, itallows long positions to makemoney at the shorts expense.Here are some compelling

examples.

TIVO TAKEOFFOne day before the stock gappedup, 17.8% of the TIVO stockfloat had been borrowed andsold by short-sellers (see Figure1). This amounted to a total of17.13 million shares worthnearly $60 million on Novem-ber 28, which meant that shortshad to buy this amount of stockto exit their positions. But thanksto a gap up the next day, the cost

TRADERS NOTEBOOK

to cover had jumped to nearly $80 million. By the close thisamount was approaching $90 million. (Remember that shorts,especially those using margin, are now underwater manytimes their initial investment.)TIVO moved above its squeeze trigger price of $6.17 on

November 29. A squeeze trigger is the short-squeeze line inthe sand that tells the market when the long-term averageshort position starts to lose money. Technically, the squeezetrigger is the volume-weighed moving average of the price atwhich shorts sold the stock. As the stock rallies back towardthis price, the greater the pressure on shorts to cover and thefaster it rallies, the more powerful this motivating force. Thisis clearly evident in the gap and subsequent move in the priceof TIVO.There is little doubt that the $0.75 gap between the close

November 28 and next days open was the result of short-covering as shorts fought with buyers to get stock in overnighttrading. This short squeeze continued for the next six daysbefore TIVO entered a consolidation phase around $8.25 (seeFigure 1). Investors who owned the stock through this periodprofited handsomely in a classic short squeeze.So what happened to the short position next? As of Decem-

ber 20, short interest had grown to 17.94 million shares or18.5% of the float, according to the latest data available fromBuyins.net. So it appears that if anything, shorts are stubborn.If TIVO remains strong, chances for another short squeezeoccurring are good.

SHORTS GET TASEREDOur next example of a short squeeze occurred in June 2007 asthe market struggled with the subprime slime credit melt. OnJune 19, Buyins.net issued a news release announcing that stungun manufacturer Taser International (TASR) had moved aboveits squeeze trigger price of $12.40 per share, with 14.45 milliondeclared shares short. At the time short interest totaled awhopping 26.9% of the float.As we see from Figure 2, the breakout was not nearly as

explosive as in Figure 1 the stock didnt gap up for threemore days. But when it finally came, it gapped up $0.79 or6.25%. Not a bad daily return.What caused the gap? A search of the Taser website

revealed that two product liability lawsuits against the com-pany had been dismissed on June 20 and 22. That may havebeen part of it, but the real dynamic could be found in the factthat the stock had moved above its squeeze trigger price of$12.41. Once this line in the sand had been crossed, shortstook it as a signal to cover. Few wanted to incur a loss.

FUELCELL: CUP & HANDLE SQUEEZEHere is another example of the power of the short squeeze.In my December 12, 2007, Traders.com Advantage articleSupercharged FCEL Makes A Break For It, I wrote: Asthe news release issued on December 5 highlights, a total of10,863,800 [FCEL shares] were sold short at an averagevolume weighted or squeeze trigger price of $9.292. This

FIGURE 1: TIVO, DAILY. Daily chart of TIVO showing the green up arrow on November 29, the day Buyins.net issued thenews release announcing the stocks squeeze trigger price of $6.17 and heavy short position. The stock continued to rallyfor the next week before consolidating in a bullish pennant pattern over the next few days.

4715K

796K18.7 M

VMA 10 10-day volume moving averageSqueeze trigger

Squeeze trigger

Pennant pattern

Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2006 2007 2008Template: Standard Symbol: TIVO

TIVO - TIVO INC. (Daily)Period Symbol Scale

8.58.258

7.5

7.0

6.5

6.0

5.5

OMNI

TRAD

ER.C

OM; S

QUEE

ZE TR

IGGE

R FR

OM B

UYIN

S.NE

T



out short squeezes that havefound a way of making lemon-ade out of lemons. In fact, theopposite is probably true themore shorts in the market, thegreater the number of potentialshort squeezes.Rather than get caught in a

stock that has been driven lowerby shorts, patient traders bidetheir time waiting for their chanceto pounce, and that is when thestock starts to rally toward orabove its squeeze trigger.Here are the steps to help find

short squeezes:

1 Look for stocks with a rela-tively high short interest asa percentage of the float.Five percent is only a sug-gested threshold.

2 Look for stocks that haverallied and are approach-ing their squeeze trigger(short squeeze thresholdlevel).

1918

17

16

15

14

1312

11

1098

8111K

721K18.7 M

VMA 10 10-day volume moving average

Squeeze trigger

June 19, 2007

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2007Template: Standard Symbol: TASR Period Symbol Scale

14.86

TASR - TASER INTERNATIONAL INC. (Daily)

FIGURE 2: TASER, DAILY. Daily chart of Taser International showing a squeeze trigger on June 19 followed by a gap upon 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 backapproximately $102,880,186 worth of shares to cover theirshort positions, which represented 12.7 days of averagedaily volume, according to Buyins.net. That kind of buyingwill drive just about any stock significantly higher, which isexactly 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 Decem-ber 20, up 35.3% from its December 5th closing price whenit broke above its squeeze trigger. But this chart also showshow quickly short squeezes can run their course. By Decem-ber 27, FCEL was back near $10.In my experience, short-squeeze breakouts tend to last

anywhere from two weeks to three months when the funda-mentals and market conditions support the rally. I have seensome last longer than six months. However, this is not a long-term, buy & hold type strategy.It is also best that besides supporting fundamentals, short-

squeeze targets also demonstrate supporting technicals(trendline support and/or bullish chart pattern).

THE ART OF FINDING THE SHORT SQUEEZEShorts (and naked shorts) are an investing fact of life andneither party is going away anytime soon. In fact, shorts gota boost recently with a change in the uptick rule, which meanssellers can now sell a stock short while it is falling. But this wont deter traders and investors who actively search

3 Look for fundamental strength or a positive corporatedevelopment. A stock that has recently issued somepositive earnings news or an exciting new productincreases the probability for a strong rally.

4 Look for technical confirmation. Bullish reversal chartpatterns like an inverse head & shoulders, double ortriple bottom, cup & handle or strong continuationpatterns like bullish flags and pennant patterns greatlyincrease the odds that it will rally. Consolidation pat-terns like a rounded bottom and areas of strong histori-cal support are other positive patterns.

5 To enter the trade, you have a number of options thatinclude buying the stock outright or buying either anin-the-money or out-of-the-money call (if you are intooptions).

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, thestop-loss might be 10% or higher. The goal is to not getshaken out of your position by normal volatility. A stopof 5% below the squeeze trigger is a good exit point.

Ignorance about short positions in the stocks you trade isanother example of how what you dont know about the

WORKING-MONEY.COM



market can hurt you. However,once armed with the appropri-ate tools and resources, traderscan use big short positions totheir favor when the right con-ditions exist.Pitfalls that catch uneducated

traders off-guard can become adistinct benefit to the initiatedwho know how to use them totheir advantage. Short squeezesare a great example and whilefinding them isnt always easy,the effort has the potential toproduce some handsome divi-dends over a relatively short time.

Matt Blackman is the host ofTradeSystemGuru.com, awebsite devoted to discoveringand better utilizing cutting-edge trading tools and winningmarket strategies. He also pub-lishes a free weekly stock mar-ket newsletter. He is a memberof the Market Technicians As-sociation (MTA) and the Cana-dian Society of Technical Ana-lysts (CSTA).

This article and articles like it can befound online at www.working-money.com. S&C

15

14

13

12

11

10.33

9

8

7

64133K

282K15.0 M

VMA 10 10-day volume moving average

Squeeze trigger

2006 2007Template: Standard Symbol: FCEL Period Symbol Scale

FCEL FUELCELL ENERGY INC. (Daily)

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

SUGGESTED READINGAnatomy of a Short Squeeze, http://tradesystemguru.com/

content/view/131/9/Phantom Shares video, http://tinyurl.com/yrbnn3Coming Up Short On Share Lending, http://

www.buyins.net/articles/nakedshortarticle.pdfFailure Is An Option: Impediments To Short Selling And

Options Prices, http://tinyurl.com/33w3ocDTCC response to naked short selling claims, http://www.

dtcc.com/leadership/issues/nss/SEC Amends Regulations To Curtail Naked Short Sales,

http://tinyurl.com/2gesd4Fined By The NYSE Over Short-Sale Violations, http://

tinyurl.com/2v84jdOverstock Shares Rise On Court Ruling In Broker Suit,

http://tinyurl.com/3drdbaHedge Funds Founder Settle Short-Sale Probe, http://

tinyurl.com/2t3xzpNaked Short Selling Explained, http://en.wikipedia.org/

wiki/Naked_shorting#External_links#External_linksNaked Short Victim Strikes Back, http://www.forbes.com/

business/2007/02/02/naked-short-suit-overstock-biz-cx_lm_0202naked.html

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

TRADERS NOTEBOOK

Documents

In Search of Next big game