A short squeeze is when a stock spikes because short sellers — who’ve sold borrowed shares in a bet that the stock price will fall — need to cover their positions. To do this, they have to buy back their shares at a higher price. In other words, it results in even more upward pressure on the stock price. But if you’re shorting a stock, you’ll need to know the warning signs that can help you avoid a squeeze.
Short squeezes are a common occurrence in financial markets. For instance, Monday’s 50%+ surge in the stock of Barnes & Noble (NYSE:BKS) was partially the result of one. Microsoft’s (NASDAQ:MSFT) investment in the bookseller — which could be as much as $605 million — was a big-time trigger.
So, what are the signs that a stock may be vulnerable to a short squeeze? Let’s take a look:
Tight float: The float is the percentage of a company’s stock that’s traded on the market. For some companies, it’s a small amount because big shareholders have major stakes. This was the case with Barnes & Nobel. As a result, the shorts had an extremely hard time finding shares to cover their positions when the stock price spiked.
- See also: 10 Short Squeeze Candidates
To spot this, a short seller can measure the tightness of the float. This is done by comparing the company’s short interest — which is the number of shares shorted — to the float. For Barnes & Noble, that ratio was a 67%. This should have been a major red flag. Keep in mind that a ratio of 10% or higher is a dangerous level.
Time to cover the short interest: You can calculate this by dividing the short interest by the average daily volume. This will show how long it will take for short sellers to cover their positions. With Barnes & Noble, it was 10 days. Consider that five days should be a warning signal.
Activist shareholders: These are highly sophisticated investors that agitate for change aimed at increasing the stock price. This is often done by using the proxy system to replace board members. Activist shareholders are often good at triggering short squeezes.
Barnes & Noble does have some well-heeled activist investors. One is Jana Partners, which has taken disruptive roles at other companies like McGraw-Hill (NYSE:MHP), where it has successfully agitated for the publisher to split into two separate companies. Another notable Barnes & Noble holder is Liberty Media (NASDAQ:LMCA), whose management team has a history of unleashing shareholder value. Its CEO, Greg Maffei, was formerly Microsoft’s chief financial officer.
Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “The Complete M&A Handbook”, “All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli or reach him via email. As of this writing, he did not own a position in any of the aforementioned securities.