Tuesday, January 13, 2009

It's the Liquidity, Stupid!

It never ceases to amaze me how often short sellers jump back in a stock that's crawling back after recently taking a huge beating based on the fact that shorting worked so well the last time. Invariably they fail to take into account the fact that (1) a good chunk of the final buyers from the last drop are willing to be unbelievably patient because of their investment style, (2) institutional investors liquidation pressure from the last time around may not only be gone, but may well be working against them in the other direction.

After watching others exploit this effect backfire into short squeezes with DRYS and other shippers, I jumped in last Thursday with a $12.75 premarket buy that I expected to be nothing more than an entry position on a nice down move and was rewarded with a 20% single-day gain thanks to a rush to cover stupid shorts from the day before. I sold enough shares to pay for my entry costs and can now ride the rest out until another tempting drop comes along (short interest hasn't diminished enough to abandon this sector so the short temptation will be there again to exploit).

Meanwhile, I had noticed that institutional buying had driven ex-Nasdaq-100 telecom LVLT back up above $1 after a brutal stretch that included dropping nearly all institutional investors in the process. Back in early November, LVLT tried to stage a comeback above $1 only to fall back brutally a few days later under heavy short selling. Eventually, full capitulation happened near $0.60 on December 30 under heavy short interest, and with all short-term longs now out, the stock has nowhere to go but up.

A large institutional buy on January 5 was the spark, and the stock was over $1 the next day and hasn't closed below it since. More institutions followed then next day (last Thursday), and the short squeeze was on, reaching 1.42 before a wave of double-down shorting pushed the price back to a $1.32 close on 10x normal volume. The next day, the smart money jumped in at the $1.17 open and pushed it to 1.65 before falling back to a 1.49 close. If you double-down shorted there and covered within the first 2 hours, you could have gone back to even. Since then, 1.13 is the lowest it's gone and it's holding steady in the mid-twenties with 12% short interest and nearly 18 days to cover. Ouch.

Lesson to would-be repeat shorts: If you're going to short a stock, pay attention to the flow of liquidity. Unless you have good reason to see an imminent liquidation pressure that wasn't there before, you're more likely to set yourself up for a short squeeze than you are to ride it down to old levels--especially if the flow of liquidity is more likely to bet against you.

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