Short Interest Is One of the Best Indicators an Options Trader Can Use

It's human nature to fear the unknown, and that can be common for many investors. But you should never let fear keep you from exploring some of the tools Wall Street pros use to build fast profits in a hurry.

That's why we're showing readers one of the best tools they can use today: short interest.

Best of all, many investors don't pay attention to short interest at all, which creates a huge advantage for anyone who does follow it. Money Morning Quantitative Specialist Chris Johnson thinks it can give you a tremendous edge, and he watches this metric extremely closely...

Shorting a stock is a bearish strategy where an investor sells a stock that he borrows from his broker. The seller hopes its price will decrease, so he can buy back those shares at a lower price. It's just "buy low, sell high" in reverse order.

To be sure, shorting a stock is not for everyone. There are big risks, especially if the market takes off to the upside. But one investor's woes are another investor's profit opportunities.

Johnson wants you to exploit other investors' risk for your own benefit...

At the end of each day, the exchanges sum up all the shares an individual stock currently sold short. This is called short interest, and we use it as a sentiment indicator. When an excessive number of shares are sold short relative to total volume, we presume the market is excessively bearish on that stock.

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In sentiment analysis, when "everyone" zigs, the market likes to zag. So when there is excessive short interest, meaning a lot of bearishness, the stock can rally big.

This is the basis for Johnson's strategy. He looks for a heavily shorted stock that is otherwise technically strong.

The herd somehow believes that things will change, but the market does not care what they think...

Get Ready for the Squeeze

A short squeeze is like a vice on the will of bears. When a heavily shorted stock starts to rally, the bears feel the pressures - the squeeze - and sooner or later, they cannot handle their mounting losses. They rush in to buy back their shorts to cut their losses. Sometimes, they even have to chase the market higher to add even more fuel to the bullish fire.

The typical result is a stock making an unusually fast move higher.

And this is where we can see the biggest gains from Johnson's strategy. He are the three simple steps he uses to profit from short squeezes...

How to Use Short Interest to Your Advantage

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Johnson has three steps to follow so you, too, can profit from the short squeeze.

Step one: Look through the biweekly short-interest data from the exchanges to identify stocks with "unusually" high short interest. What's unusual? When short interest divided by the average daily trading volume (called the "short interest ratio") moves above 6.0.

If you can, look for stocks where short interest is actually increasing. This tells you when the bears are getting even more bearish. They may soon regret that.

Step two: From those high short-interest stocks, look for those in a strong technical uptrend. A good rule of thumb is that the stock trades above its rising 50-day moving average.

It's this combination of high short interest (bearish sentiment) and bullish technical strength that creates a short-squeeze situation.

Step three: Identify the "trigger price" by analyzing recent price activity, support and resistance areas, and the potential for new highs. This price level is where the shorts are likely to throw in the towel and begin to cover (buy back) their losing positions.

This step is not as complicated as it might seem. Just look at the chart and eyeball a price level that seems to be acting as a ceiling. Once breached, the bulls take over and do the rest of the work.

When Johnson first wrote about short interest earlier this year, he showed how short interest set Allegion Plc. (NYSE: ALLE) stock up for a rally. At that time, Allegion just moved above its trigger price of $84.00. It traded above its rising 50-day average, and its short-interest ratio was 6.9 and rising. Given its average trading volume, it would take almost seven days before the bears would be able to cover their shorts.

Johnson expected the stock to quickly rally to $88.00, where there was significant resistance on the chart and a 4.8% gain. Within 13 days, it made it to $87.00 before the chart showed that the bulls had gotten tired.

The moral of the story is that short interest correctly identified a potential fast mover. However, since there are no absolutes in the market, we got a technical signal that the party was over before the ultimate price target was reached. It was close, but the trade should always be closed out when the market says so.

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