What’s going on here?

The best-performing stocks of 2021 so far have one thing in common: professional investors hate them. While the most extreme example is video game retailer GameStop (ticker: GME), which has now seen its share price rise almost 1900% this year, the 10 most-shorted stocks in the Russell 3000 index have on average gained a jaw-dropping 73% in January alone.

GameStop has moved significantly higher since this chart was made…

What does this mean?

A heavily shorted stock is already a promising candidate for a “short squeeze”. As Carl explained a few days back, this involves a sharp jump in an investment’s price forcing traders who’d bet on it falling to curtail their losses by buying – sending prices up still further. But the recipe for a truly enormous rise à la GameStop contains other important ingredients.

⚙️ High short float + low trading volume

The “short float” is simply the number of shares currently being shorted as a percentage of total shares available for trading. The higher this ratio, the more extreme the potential shortsqueeze: a larger proportion of investors will be competing to “close out” their shorts if the price rallies.

Trading volume, meanwhile, is like a fire door: if everyone’s trying to get out at the same time, a smaller door means it’ll take longer – increasing the sense of panic. The “days to cover” ratio (number of shares shorted / average daily volume) indicates how long it’d take shorts to cover their positions – and the higher this ratio, the greater the upward pressure on price when they do so. You can easily screen for stocks with these characteristics using websites like finviz.com.

📈 Existence of a bull thesis

It’s worth remembering that GameStop’s share price was already on the up well before it began trending on Reddit. As the chart below shows, investors’ ears began to perk up last August after both the contrarian investor made famous by The Big Short and the co-founder of online pet store Chewy built significant stakes in the business – with the latter adding several digital-savvy colleagues to GameStop’s board.

While short squeezes don’t require there to be a “bull thesis” that a stock is undervalued, , the big-money moves are often fueled by improving investment fundamentals and enthusiasm among value investors.

GameStop's share price

🚀 Rising retail investor interest

Small-time retail investors played a huge part in GameStop’s surge. The collective force of forums like Reddit’s r/WallStreetBets allowed individual traders to take on Wall Street itself: their mass buying of GameStop stock and call options forced investment banks to hedge their exposure and buy the stock – pushing up prices still further and encouraging even more short-sellers to close out. Increasing retail-driven option volume is the last ingredient for an epic short squeeze.

Why should I care?

A strategy of simply buying the most-shorted stocks would have served you well over the past year.

But not every stock on that list will experience a GameStop-style short squeeze. Those seeking more such opportunities could narrow things down based on the three factors outlined above. What’s currently ticking the boxes? Movie theater chain AMC Entertainment (AMCX) and homeware retailer Bed Bath & Beyond (BBBY) are already getting a lot of investor attention – but Ligand Pharmaceuticals (LGND), streaming service FuboTV (FUBO), and real estate investment trust Macerich (MAC) may be promising alternatives.

Just remember: while correctly identifying the next short squeeze could lead to massive gains, it’s vital you’re aware of the risks. These are often hugely speculative stocks, and there’s a strong chance you could lose all your money – so only invest what you can afford to lose. What’s more, buying into the next big winner is only half the battle: you’ll still need to sell at the right time, given that the majority of short squeezes end in tears. I’ll be covering selling strategies in my next Insight – so stay tuned.

A short squeeze in 2008 briefly made VW the world’s most valuable firm. Briefly…