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When the facts change, I change my mind. What do you do, sir? - John Maynard Keynes

There's a much lesser known quote which goes like this: when you become more acquainted with the facts, your opinion can change too.

In a previous article, I suggested that AMD (NYSE:AMD) was overvalued and faced a high risk of bankruptcy or would at least need to tap the markets for more equity capital. The insight for this came from using a financial tool called the Altman Z score, which uses various figures from the balance sheet and income statement to determine how likely a company will go bankrupt in the next few years.

Here is the Z score formula that I included in my previous article.

Z = 1.2A + 1.4B + 3.3C + .6D + E, where

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = EBIT/Total Assets

D = Market Cap/Total Liabilities

E = Sales/Total Assets

Using the latest quarter's figures, annualized, AMD's Z Altman score is 1.2X.28 +1.4X (-1.4) +3.3X.08 +.6X.64 +1.4 = .43.

If I had used the annual figures, instead, then AMD's Z score would be (-.8).

What do these figures mean? Well above 3, a company is considered safe, between 1.8 and 3 there is some doubt about the future of a company, and below 1.8, the company is predicted to have a high chance of bankruptcy within a few years.

High short interest

I still stand by that analysis, but you can't only rely on long-term fundamentals when thinking of buying/shorting a stock. One important thing I ignored was the very high short interest in AMD at the time. That short interest has now risen even higher since that article was published and presents a big risk to shorting AMD's stock. It also presents an interesting long side trading opportunity.

Here is a table of the short interest.

(click to enlarge)

Data source: NASDAQ

And here is a graph of the days to cover short interest with volume of shares traded included.

The days to cover short interest metric fluctuates quite a bit as it depends on the volume of shares traded, which is much more volatile than the number of shares shorted.

The last time the days to cover short interest was this high was in March of this year when it hit 7.5. This was right before the stock price would shoot up from $2.5 to over $4 on the back of a massive short squeeze.

(click to enlarge)

This short squeeze was triggered by news that AMD had won the contract to supply Sony (NYSE:SNE) chips for its next generation video console and was likely to win the Microsoft (NASDAQ:MSFT) console as well.

I don't believe that there has to be some development or positive news to trigger a short squeeze; sometimes it can happen spontaneously.

For a longer term view of AMD's short interest and stock price, here is the 5 year chart of AMD's short interest and price action (Unfortunately, the latest short interest data isn't included, but imagine the blue line rising even further upwards and to the right).

AMD Short Interest Chart

AMD Short Interest data by YCharts

I like this chart because it demonstrates two important things.

  1. The short interest has risen over time even as the share price has declined. This really supports the argument that the share price over the long term is driven by a company's fundamentals, not anything else.
  2. In the short term however, the short interest and share price are negatively correlated and a stock is capable of quite severe price movements based on short squeezes or long position liquidations.

A possible long trade

Now how high could a short squeeze propel the stock? I think the stock could break above the $4 level and even retest the $4.50 mark. Remember though, that this is just a short term trade. I don't think the stock is worth anything more than $2 per share, which is 15x consensus earnings for 2014. The stock isn't likely to stay above the $4 level for long, so you need to be mindful that the stock could drop as quickly as it rises.

If the share price does rise and the volume spikes, then it's safe to assume that a short squeeze is on. The thing to watch out for is how much short interest remains and how many days to cover that short interest. The days to cover short interest number is especially important, since it tells you how easy or not it is for shorts to cover their short positions. Provided that number stays high, then a short squeeze remains in place.

However, since there is quite a lag (two weeks) in the reporting of short interest information, you need to rely on a data source that is more immediate. The one metric that is updated on a daily basis is the volume of shares traded. This is the most important figure for determining the days to cover short interest number, as the short interest itself doesn't change that much.

Risks

Obviously, relying on short term movements in a share price is riskier than betting on longer term ones. Moreover there may be a good reason for why such a substantial short position in AMD stock has been built up. Perhaps the smart money has caught wind of some bad news, like AMD planning to raise additional capital through issuing new equity.

Conclusion

Due to AMD's high short interest, it would be quite dangerous in my opinion to continue shorting AMD's stock. In fact, so high is the short interest that a short term buying opportunity has arisen, which should last as long as the short interest - or to be more precise, the number of days to cover the short interest - remains high.

Source: Advanced Micro Devices Shorts Need To Form An Orderly Queue