jaudio shorts

The Art of the Short Squeeze

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A few weeks ago I laid out my goals and overall strategy for round 2 of the Strategy Lab Open. After several rounds of testing, I am sticking with the overall strategy with a few modifications. The strategy involved going after what I call the "ugly, the beat up, the disowned, and dismembered. I began testing the strategy, with some interesting results. In three short weeks, I dodged bullets, avoided land mines, and struck gold a time or two. I only had a couple big losers, but my success wasn't necessarily because of my investing acumen. Some of it I chock up to luck, which is why I am modifying the strategy. After all, the goal here is to make money.

I have been testing the art of making money off of a "short squeeze". When a stock is sold short, an investor borrows a share, sells it on the open market in the hopes the stock price goes down. At a later date, the investor buys the share back and either books profit if it has dropped in price or books losses if it goes up in price. A Short Squeeze happens when a stock that has been sold short suddenly goes up in price causing the short sellers to "cover", that is, short sellers buy the shares back, which in turn causes the price to go higher. Short selling, which cannot be done in the SLO, can be risky business. Investing in stocks that have been beaten up and have a large amount of shares sold short, can be near suicide. Here's what happened to me in the testing phase.

A few factors went into my selection of stocks, but the main goal was finding stocks with a large percentage of shares sold short, and were also trading within 5% of their 52 week lows. My initial list consisted of about 100 stocks, and I bought close to 30. Some of the darlings were Countrywide (CFC), MBIA (MBI), and Ambac Financial (ABK). There were really too many companies to choose from since overall short interest in the market was on the rise, so several companies had been beat up during the short selling cycle.

Things got off to a bad start when a keystroke slip bought 12,222 shares of CFC instead of 1222 shares. Lucky for me, I was able to sell 11,000 shares and book a tiny profit to reduce my position to what it was supposed to be in the first place. I started buying MBI at $24.10, and ABK at $17.55. (Take a look at the price history of MBI and ABK to illustrate how bad these were hit after I started buying). I started buying those and many other positions just before they really tanked. Despite seeing several of my initial buys go south almost immediately, most of them turned into profits. How? First and foremost, I started buying small positions and doubling down as they went down by at least 5%. I didn't use limit prices on buys because volatility was through the roof, and some took 10, 15, or even 25% hits in just one day. When I posted my thoughts on my precarious position in CFC, the market helped me the day after when CFC soared on buyout news and I was able to get out with a 51% gain. MBI and ABK were not as profitable, but I kept buying as they went down until they popped, then I was out. Since all of these positions were part of practicing this short term trading strategy, most of them are already gone. I have held onto one, ADS, and I missed the big pop so I will probably sell soon for a loss. The toughest thing about this strategy was the thought of losing even more money as I hit the execute button when I doubled down on a stock I hated. I guess I'm a glutton for pain.

The key to winning in January hinged on two things: hanging tough and doubling down. My initial buy was $10k. I then would double to $20k and then stop at $40k. In hindsight, it was a bit reckless because any one of the positions could have tanked even further, and losing 10% at each leg of buying would have equaled around $7k of losses. I'd need several stocks to significantly pop to recover, and thankfully I didn't lose my shirt. No strategy is bullet proof, and my first experience left mine with so many bullet holes to analyze about how I came out unscathed.

I am now buying in with initial purchases of $5k, and I will double down on a 5% -10% drop and triple down on a drop greater than 10%. I will cap my purchase at $30k. Included with this is initial buys using limit orders placed at least 5% lower than what I am comfortable with. Once I am down 10% after my last buy, I sell for a loss. Out of about 30 limit orders I placed recently, only 6 hit the limit with a few missing by only a few cents. A couple popped 15% after I barely missed them, but no harm, no foul. In order for me to make some real money, I'll have to take some hits as I am easing into the position. I would eventually like to have 20% of my portfolio invested in short squeeze plays, but right now the amount of short interest is decreasing, meaning I probably won't reach my entry points. I may be playing a little too conservative, but patience always pays off in the end. Playing some short squeezes won't necessarily make "the big bucks", but they do have the potential to add a few percentage points of gains. I also noticed that my short squeeze candidates in January weren't moving up and down with the broad market, so when the market continued getting hit, most of the short squeezes were left unscathed since they were already "at bottom".

The market is real confusing right now. We have people screaming recession, people denying recession, flirtations with bears, fear on inflation, the ongoing credit crunch, and the list goes on. China is starting to come back a bit, which is bad for me since I have a nice chunk of FXP, the Ultra Short China ETF, and the emerging markets have recovered some hurting my short plays on those markets. Nevertheless, I am attempting to diversify into every asset class, either long or short, to ease the pain. The riskiest parts of my portfolio sit with SZK, the Ultra Short Consumer Goods ETF, the aforementioned FXP, and short Japan and emerging market ETFs. It equals around 20% of my portfolio, and may become more if they drop to my buy limit price for each. Eventually I would like to hack it down to 10% and increase my position in bond ETFs, with some money being dedicated toward going long in the market. My portfolio will be doomed if the US and overseas markets catch new fire and rally upward, but I do not expect the USA to rally any more than 10%. China seems to be bubbly, and some good money is made when long in the bubble, but I am confident that China will be pulled down by the USA. I am not a believer in "decoupling", although I do admit we don't all move in concert. Let's just get this recession over with and pass out awards to the bottom callers.

The romance of the market . . . just when you think you have it all figured out, you must go back and rethink.

---Jonathan