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Every several years, short-selling hedge funds get a surprise visit from short-squeeze investors. 

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Consider GameStop (NYSE:GME). $10,000 invested in GME during its 2020 trough would have turned into $1.8 million during its short squeeze in 2021 — enough for most Americans to retire on.

A similar squeeze on KaloBios orchestrated in 2018 by controversial investor Martin Shkreli returned 10,000% in five days. There’s no financial rule that prevents stocks or call options from rising indefinitely if people are willing to pay up.

But finding these short squeezes involves more than buying up highly-shorted stocks. These companies can spend years (or decades) languishing in obscurity.

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Instead, I have a system I call Coiled Spring Investing, made up of three rules that have predicted countless short squeezes, from Tilray’s (NASDAQ:TLRY) 270% rise in 2021 to AMC’s (NYSE:AMC) 6x bounce. It also helps keep investors away from duds that go to zero.

What is Short Squeezing?

Before getting into Coiled Spring Investing, let’s consider what shorts and short squeezing really mean. Once you start looking, you’ll find short trades everywhere.

• Stocks. Hedge funds and long-short traders will often bet against a stock by selling shares they don’t yet own.

• Commodities. Producers will close out price risk by selling crops or other commodities in the futures market before they’re produced.

• Foreign Exchange. Currency swap counterparties gain when the other side loses.

• Options. Long puts and short calls are designed to go up in value as the underlying security falls in price.

In all of these instances, investors are looking to gain when prices go down. It’s a smart way to reduce risk and stabilize your stock portfolio performance.

But sometimes, greed gets the better of Wall Street hedge funds. Rather than reduce risk or seek minor wins, these firms turn their attention to Moonshot profiteering. According to financial analytics firm S3, investors managed to sell 141.8% of GameStop’s float short by early January 2021. In other words, there weren’t enough available shares for short-sellers to close out their positions.

That creates the potential for a “short squeeze,” an explosive rise in share prices that occurs when shorts are forced to close out positions.

Making Money in a Short Squeeze

Short squeezing works when a small group of buyers triggers an avalanche of more buying.

1. 
   

   1. Initial buying. Investors buy a highly shorted stock, sending prices up a small amount (perhaps 10%)

   2. Short-seller rebalancing. Some short sellers see the gain (which grows their short exposure by 10% on a dollar basis) and buy back 10% to bring their exposure back to par.

   3. More price rises. These transactions drive prices higher, incentivizing buyers and rebalancers to buy more shares

   4. Panic buying. Leveraged short sellers start getting margin calls and buying accelerates further.

In other words, initial investors use other people’s money to their advantage. By starting a snowball effect, they can turn a tiny investment into outsized gains.

The buyers however, also need to know when to sell. Once the short sellers close out their positions, the panic buying stops and prices return to their original level. That can take anywhere from 50 to 300 trading days.

Coiled Spring Investing: The Three Rules for Buying Short Squeezes

Surprisingly, most hedge funds aren’t that stupid (presumably, they’re the ones who paid for the 50-hour econ course). History is littered with former high-flyers like Fitbit and dying mall retailers like JC Penney where hedgie short-sellers made small fortunes. Academic studies show that the average highly shorted stock produces negative returns for owners over time.

But greed often gets the better of Wall Street insiders. According to financial analytics firm S3, investors managed to sell 141.8% of GameStop’s float short by early January 2021. In other words, there weren’t enough available shares for short-sellers to close out their positions.

This sets up a play I call the Coiled Spring. When so many company shares are sold short, even small amounts of buying can trigger a run.

Highly shorted stocks tend to have higher volatility. They can also occasionally “go to the moon.”

Coiled Spring Investing Rule No. 1: High Short Interest

Coiled Spring plays start with having many shorted shares as a percentage of its free float. I look for companies with >40% short interest, but the figure can be as low as 20% if the stock is unusually illiquid or has a high volume of options written on it — bonus points for companies where the short-sellers are highly leveraged. These are all elements that create the potential for forced buying.

Avoid assets that macro funds use as “pair trades.” Stocks like Apple and Ford might have hefty short interest, but short sellers are using the trade to close out systemic risk rather than gambling on a particular price direction.

Coiled Spring Investing Rule No. 2: Cheap Entry Price

Buying short squeezes involves finding down-and-out companies where every squeezed dollar increase means significant returns. (Note: that’s opposite from the Momentum Master trade where you’re looking for rising stars). 

That’s because short squeezes provide only a temporary boost in share values. When you only have two to three weeks to make a profit, it helps to get in at $1 rather than at $100.

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Alternatively, experienced investors can also consider call options. These riskier investments can help investors build a stake in a $100 stock for a $2 to $5 upfront investment.

Coiled Spring Investing Rule No. 3: Love for the Company (or its Stock)

Regulators have beefed up rules for market manipulation since the days of Silver Thursday. Few hedge fund managers want to risk jail time to make profits, so they tend to stay away from starting price squeezes in mid-cap and large-cap stocks. (These shenanigans are now generally limited to micro-caps).

Instead, most short squeezes now rely on retail investors and social media. Swarm investing is far harder to label as “market manipulation” because there’s no conspicuous cooperation among those involved.

That means short squeeze targets are often retail-oriented names that produce recognizable products. It’s easier to get young investors interested in a marijuana firm like Tilray than in a for-profit prison company like GEO Group (NYSE:GEO). So, when you’re buying into a short squeeze, make sure others love the investment as much as you do.

How to use Coiled Spring Investing

I know, it’s often tempting to buy up highly shorted stocks in hopes of landing a short squeeze. But short interest is only one element of a great short-squeeze play. You also need enough investors to trigger a squeeze.

By following the three rules I outline for Coiled Spring investing, you’re far more likely to hit on companies that go 5x…10x…50x and avoid stocks that fizzle out.

Want to learn more? Make sure you sign up for the free Moonshot Investor newsletter, available at this link.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.

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