I have promised in yesterday’s post to create a list of stock with the highest short interest ratio. So here it is:

Now that I’ve listed the stocks, what exactly does “short interest ratio” mean? In short, short interest ratio means the percentage of shares sold short with respect to the daily average volume. So technically, all the above stocks should be avoided like the plague, because a lot of investors are betting against them.

Now, the question, should one short a stock with a very short ratio (such as NATR), a logical answer would be yes, because everyone else thinks and acts as if it’ll go down forever. But shorting a stock with a very high short interest ratio can be a very dangerous game. Let me tell you how…

Let’s say you shorted a 1,000 shares of NATR yesterday just before the market close. You would have made so far today $300, because the stock went down 30 cents. Now let’s say, around 11:30 AM, one of the following happens:

– An institutional investor looked at the stock and liked it, so he bought one 100,000 shares, or about 4 times the daily average volume.
– The owner of Nature’s Sunshine Products decides to take the company private, and so he buys back all the stock.
– A rumor spreads that Nature’s Sunshine Products will be bought by a very large company

When any of the above happens, then the stock will jump, at least 20%. Now what will happen to all the investors shorting the stock? Usually, when someone shorts a stock, he adds a stop loss automatic order for contingency, so when the stock goes up more than a certain amount, he exits his short position automatically by buying back the stock (see an introduction to shorting stocks). A this point, an avalanche will start forming: an investor will buy back the stock (which he borrowed and sold immediately), and then the stock will go up beyond the stop loss limit of another investor, who will again buy back the stock, pushing the stock price even higher, and so forth… This avalanche is called a short squeeze. Of course, day traders will notice the trend, and will start buying the stock to make money, and the stock will go even higher. When the market closes the stock will probably be trading nearly a 100% higher (which means that you will lose $10,000 for covering your position for these 1,000 stocks that you shorted). Shorting is a very dangerous game!

I think a correct use of the list above is to see which one of the stocks is worth buying long, and not which one is worth shorting… Never short a overly shorted stock!