The Short Squeeze. Looking for a good stock trading technique? There are the obvious methods a trader can use to figure out where a stock is likely headed to next...chart reversal patterns, technical momentum, improving fundamentals, etc. The challenge with these methods is, thousands of other traders are looking at the exact same tips and tools. Sometimes, the more obscure stock trading tools like short sale interest can offer an advantage. Never heard of it? Don't worry - short interest is one of the relatively-untapped trading tools out there. Yet, finding a so-called 'short squeeze' scenario may well generate enormous stock returns in a very short period of time.

First things first though - a quick explanation of short selling for anyone who may not be familiar with it. Unlike conventional 'buy low, sell high' strategies, traders also have the option of selling a stock short...just meaning they're selling a stock they don't own. Why would they want to do this? If they believe a stock is going to decrease in value, they can sell it now at a higher price, and then buy it back later (called 'buying to cover') at what is hopefully a lower price. Essentially, it's the 'buy low, sell high' process done in reverse. *

The attraction to the strategy is clear...a trader does not have to rely on a bullish market to sustain growth of his or her portfolio.

That said, short selling presents a much different kind - and much greater degree - of risk to those who engage in the practice. Whereas the maximum risk in owning a stock ('going long') is simply the amount of the invested capital, with a short sale, the risk is theoretically infinite. How so? There's a cap to how much a stock can fall - it can't be valued at less than zero. However, there is no cap at all on how high a stock can climb. As such, for someone betting against a stock (expecting it to go lower), there is no monetary limit to how wrong they can be.

Let's walk though an example. Say trader-A likes XYZ stock, and it's currently trading at $5.00. He invests at $5.00 per share, then the stock falls all the way to $0. What's his loss? Only $5.00 per share. Now say trader-B dislikes XYZ stock and thinks it's going lower. He sells XYZ short for $5.00 per share (and pockets that $5.00 immediately). But, rather than falling, XYZ rises to $10.00. How much is trader-B's loss? It's also a $5.00 per share loss. But what happens if XYZ moves to $20? Now it's a loss of $15 per share. At $40, now the loss is $35 per share. There is no maximum loss.

Fortunately for their own sake, most short-sellers know the risk they're assuming, and have taken defensive measures. Those measures, though, are also the basis for the short squeeze strategy...looking for a scenario where a whole lot of short positions are going to have to be covered.

Remember what we said above? To 'cover' a short trade, those shorted stocks have to be bought by the short seller. Now think back to your early trading lessons....specifically, supply and demand. If a short seller - or a bunch of short sellers - are forced out of a short position all around the same time, then XYZ stock's market 'auction' process is injected with a huge dose of demand - all those traders covering their short positions are simultaneously being forced to buy shares back, sometimes at any price. This cumulative buying demand, ironically, can cause a stock's price to rise even more than it would without the newly-created demand.

So, a 'short squeeze' situation is created when a stock has a major portion of its float held as short positions, and the stock moves up just enough to start what is essentially a chain reaction of short covering.

Since each trader has a different 'uncle point' (different prices at which a short trade has to be exited before any more losses are taken), the stops or exit point for all those short trades may be pegged across a range of price levels. A small move may shake out the short positions with a lower exit trigger, but that influx of buying may trigger the next tranche of short exits when the stock's price moves higher. Then, that next wave of buying may force the stock's price to move up into the next level of short-exit triggers, and so on, and so on.

The irony is, the worse it gets for the short sellers, the better it gets for the owners (long positions). Why? A short squeeze can really force a stock's price higher in a short span of time.

Needless to say, a high short interest can actually be a bullish thing, provided the stock is starting to move upward again...at least enough to start shaking out that lowest first level of short stop-out levels.

Looking for a specific number? There's no set rule, but a short interest ratio greater than 30% is pretty high. Yet, we've seen short interest as high as 80% in some cases. For larger companies, you'll rarely see short interest larger than 1% of the float, simply because so many funds and pensions own big stocks. For smaller companies (and even bulletin board stocks), short ratios of 30% or more are not uncommon. Just keep the trend in mind...you want to get bullish when short interest is shrinking as the stock's price is rising - not the other way around. The 'other way around' isn't a short squeeze at all.

And how does a trader get this information? There are a few data services providing it...some free, some paid. Shortsqueeze.com sells the information via a subscription on over 14,000 stocks, and the data is relayed to subscribers before it's published as public domain (i.e. free) data. The New York Stock Exchange and NASDAQ will provide the information for free, but only on monthly basis...and it's delayed a few days.

In many cases, the basic short ratio data can also be found on the free portion of a financial/investment website. Yahoo! Finance updates short interest data on all major stocks about once per month. BigCharts.com also lists some of the biggest short interest ratios for NYSE-listed equities.

Though you do indeed get what you pay for, just because you get short interest information faster than the general public doesn't mean you can necessarily do more with it. More often than not a short squeeze uptrend lasts for a few days to a few weeks, meaning the free information might be sufficient.

As far as being a stand-alone trading technique, it may be tough (though not impossible) to use a short squeeze strategy alone. You'd probably need a way of monitoring the subtle changes in short ratios for hundreds if not thousands of stocks. Doing that work on your own is too much for the average investor to take care of. Instead, we suggest using short interest information as supporting information. In other words, if a stock is trending higher and short interest is shrinking (yet is still strangely high), then you may be seeing a short squeeze in action. Scenarios like that can have better bullish success rates - and bigger rallies - than an uptrend not fueled by a hefty amount of short covering.

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* A margin account is required to sell short, and most traders need to pre-qualify with their brokerage firm to take on short positions. Also, the exchanges are quite strict on the practice of short selling, and it can not be done nearly as easily as making a straight-forward purchase of a stock. Nonetheless, the practice is not uncommon, and can be fruitful.