Stocks with a high short ratio can be a double-edged sword. No doubt the general sentiment on the investment is hawkish. On the other hand, the shares sold short are like an ‘IOU’ for a future purchase of stock. If prices rise too quickly and enough short-sellers hear their broker yell ‘margin call’, then the situation can escalate much like pouring gas on a fire.
But what are some clues that the stock may experience a future boost?
High Options Volume
In April of 1998, the Journal of Finance released a report analyzing the relationship between option volume and stock prices. Their conclusion was that evidence links informed traders buying the corresponding options contracts before the underlying share price moved profitably.
Based on this report, if stocks with a high short ratio suddenly saw an abnormal amount of call options being traded, this could suggest that an informed trader is quietly accumulating a position in anticipation of a large stock price move; this in turn could lead to a flurry of short covering. By comparing your list of high short interest ratio stocks to ones with an abnormal surge in call options trading, you might find a common stock to watch closely.
Insider Buying and Institutional Purchases
Besides analyzing the volume of call options being traded, you can also spot informed investing by following large institutional purchases and insider buying. If insiders are accumulating shares, this could suggest management confidence with future growth prospects. Also, institutions buying up shares can create investor confidence and long-term support as other traders piggy-back on their stock picks.
Listed below are the companies that have over 10% short interest, over 10% insider ownership, and a 5% increase with insider buying over the last 6 months.
Of course, the higher the insider ownership and the more shares they are buying will mean a more relevant pick.
For our next list we will consider a stock universe with a short ratio of over 10%, an increase of net institutional buying 20% and over, and total institutional ownership that is over 70%.
Other Clues as to Short Covering
Technical analysis of the stock can also give clues as to when short-sellers might cover. This is also true when the markets turn from a bear trend to a bull. Granted, it’s not within the scope of this article to get into technical indicators or momentum pops, but looking at a chart before you buy a high short ratio stock would be prudent.
If you keep these stocks with a high short interest ratio on your radar and look for a major purchase in call options, insider buying, and institutional accumulation, you just might be watching the countdown to a monumental lift-off.