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One of my 10 "Trading Commandments" is "Short sellers are usually a bull's best friend." That's because short interest, especially when there's too much of it, often provides the fuel for strong rallies.
It sounds counterintuitive, but it's true. How does that work?
It's fascinating, it has everything to do with human nature, and, best of all, it can be one of the most wildly profitable events for any stock.
You just need to make sure you're on the right side of it, and with Best Buy Co. Inc. (NYSE: BBY), this is your big chance.
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"Investing 201": How a Short Squeeze Works
We know that an investor who's bearish on a stock can short it by selling it in the hopes that he can buy back the shares at a lower price and pocket the difference.
Short interest is the sum of all shorted shares on a stock that have not been covered or closed out by buying back the stock.
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The problem for the short sellers - "shorts" - arises when the stock moves against their expectations (i.e., goes up). That's when short sellers are forced to "cover" their losing positions on a stock.
This results in unusually strong buying volume - known as a "short squeeze" - that drives a stock price higher.
The result is typically that a stock makes an unusually fast move higher. And it's this type of move that generates oversized profits... IF you can spot the short squeeze before it happens.
One of the best ways to spot upcoming moves - and it's one I use regularly for my Seismic Profits Alert subscribers - is to look at a stock's typical price action around earnings. Most will tell you what a stock typically does after earnings.
But I like to look at what a stock does heading into its report, because you'll often see a pattern of strength or weakness as traders anticipate the report.
Finding high short interest on a stock that tends to rally into earnings is a doubly bullish play in my book, especially if you leverage the expected pop with options.
Such is the case right now with Best Buy; I just recommended a play on these shares to my Seismic Profits Alert subscribers. My subscribers have had the chance to rake in plenty on similar and related technical setups in shares before, like 153.59% and 276.47% on FCAU, and 100% and 131.85% on CHRW. You can go here to learn a little bit more about how my service works.
Best Buy reports earnings on May 24, a little less than three weeks from today. Last quarter, the stock rallied about 11% in the three weeks leading up to earnings. The quarter before that, the stock gained 4% in the prior three weeks.
Currently, Best Buy is pulling back after a five-week, 17% rally. And we saw some short sellers close their positions during this run-up.
But short interest remains high. In fact, around 30 million BBY shares remain short, which represents a whopping 17% of the stock's float.
Normally, I consider 6% of the float the threshold for a juicy short-squeeze opportunity, but this setup, with much better than double the short interest I like to see, is basically irresistible; there's plenty of "shorting fuel" for another rally.
Now, with earnings on the horizon and its 50-day moving average pointing higher and poised to provide support, I see Best Buy ready to embark on another pre-earnings rally. And with high short interest, any uptick could start the shorts covering their positions.
How powerful can a Best Buy rally be?
Well, look at what the stock did after reporting earnings in November 2017. The shares rocketed nearly 50% in a little more than two months. But what made the rally go was the shorts covering 10 million shares of losing bets. This massive unwinding of short positions added substantial buying pressure that propelled the shares to an all-time high.
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About the Author
Chris Johnson is a highly regarded equity and options analyst who has spent much of his nearly 30-year market career designing and interpreting complex models to help investment firms transform millions of data points into impressive gains for clients.
At heart Chris is a quant - like the "rocket scientists" of investing - with a specialty in applying advanced mathematics like stochastic calculus, linear algebra, differential equations, and statistics to Wall Street's data-rich environment.
He began building his proprietary models in 1998, analyzing about 2,000 records per day. Today, that database, which Chris designed and coded from scratch, analyzes a staggering 700,000 records per day. It's the secret behind his track record.
Chris holds degrees in finance, statistics, and accounting. He worked as a licensed broker for 11 years before taking on the role of Director of Quantitative Analysis at a big-name equity and options research firm for eight years. He recently served as Director of Research of a Cleveland-based investment firm responsible for hundreds of millions in AUM. He is also the Founder/CIO of ETF Advisory Research Partners since 2007, noted for its groundbreaking work in Behavioral Valuation systems. Their research is widely read by leaders in the RIA business.
Chris is ranked in the top 99.3% of financial bloggers and top 98.6% of overall experts by TipRanks, the track record registry of financial analysts dating back to January 2009.
He is a frequent commentator on financial markets for CNBC, Fox, Bloomberg TV, and CBS Radio and has been featured in Barron's, USA Today, Newsweek, and The Wall Street Journal, and numerous books.
Today, Chris is the editor of Night Trader and Penny Hawk. He also contributes to Money Morning as the Quant Analysis Specialist.