Usually, I discuss using short interest data as a bullish indicator on a technically strong stock … the idea being that a highly shorted stock that’s trending higher is more likely to force the short sellers to cover their positions, sending it even higher. Typically, these short squeezes strengthen an already strong trend.
There is another scenario, though — the one where the shorts are right. Short sellers can cause a short squeeze on a stock that has been trending lower when they lock in profits. Mechanically, it works the same, as short sellers have to buy shares back to close their profitable positions. The added buying creates demand for the shares, and they will tend to outperform the market over the short run.
Note that I said the “short run.” Just because a stock gets a short squeeze doesn’t mean it’s a good buy at that time. As a matter of fact, many well-known companies that recently have seen short covering rallies but should remain out of your portfolio — the short covering pop is likely to be nothing more than a speed bump before these stocks move lower.
Here are a few to avoid: