Investing Cheat Sheet: How to Find the Next Short Squeeze

Source: Thinkstock

Source: Thinkstock

On Tuesday morning we saw shares of 3D printing companies rack up huge gains. Here are just a few examples:

There was no strong fundamental news, but there was one thing driving these stocks — short covering. Investors had begun to heavily short these stocks, especially since the last uptrend ended in December. These traders saw a group of companies that were universally loved by the market and that traded at seemingly absurd valuations. After some momentum had developed on the downside, the shorts began to pile in.

However, the fundamental story behind the 3-D printing stocks hadn’t radically changed: 3-D printing, or additive manufacturing, is developing to the point where it is going to change manufacturing. Prototypes for new products can be designed on a computer and “printed” now with relative ease, and the companies involved stand to benefit tremendously even in a tepid economic environment.

So as these stocks came down, the steadfast bulls began buying shares and setting a floor as the bears held their short positions. Eventually, the buying power overwhelmed the selling power and we started to see a steady uptrend. The result was that on an up day in the market — like Tuesday — the shorts finally caved and started a buying stampede that incentivized more short sellers to exit their positions and so on.

From a trading perspective, this phenomenon is extremely educational, and I think we can learn something from it in order to become better traders because we can better isolate the conditions that lead to such a powerful short squeeze, which can make you a lot of money in a short period of time. So let’s see what attributes these stocks/companies possess that led to this short squeeze.

Source: Thinkstock

Source: Thinkstock

1. These stocks are in a secular bull market

The 3D printing stocks are in a secular bull market. Even after the pullback at the beginning of the year, they were still substantially higher than they were a few years ago. Furthermore, they are growing revenues and earnings at a rate that far exceeds the “average” rate for stocks in the market and they are poised to grow in virtually any economic environment (except “Armageddon.”) So the first rule is to find something that is in a long-term uptrend for long positions, or something in a long-term downtrend if you are looking for short positions.

Source: Thinkstock

Source: Thinkstock

2. They had found a clear bottom and had begun trending upwards

As a trader you don’t catch a falling knife. That’s for value investors who intend to hold their positions for years. You wait for the downtrend to end and to reverse course. So 3D Systems peaked at nearly $100/share and then fell to about $45/share and started to slowly trend upwards. As a trader it is okay if you miss the first 10-15% because the rapid upswing will occur in the middle or near the end of the bullish move. Traders who saw 3D Systems trading in the mid $50’s would have recognized this pattern and jumped on board even though they knew the stock had already risen nearly 20%.

Source: Thinkstock

Source: Thinkstock

3. These stocks had very high short interest

If you’re looking for that big pop, you need to find companies that generate a lot of short interest. This short interest combined with the long-term secular bullish trend is what will give you the upward spike you are looking for. You can find data on the internet for a company’s “short interest,” or the percentage of the company’s total shares that are sold short. In such situations you want at least 5 percent, although a higher number will give you a larger move. For instance, 3D Systems had a short interest of over 30 percent.

The bottom line is that as a trader you want to find a situation with two things in your favor: the direction of the stocks’ move and the size of the stock’s move. The three steps outlined above are not guaranteed to work, but they can certainly put the odds in your favor.

Disclosure: Ben Kramer-Miller is long Stratasys.

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