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.