Risk Ratios: An Early Indication of a Short Squeeze

Risk Ratios Intro

Many years ago, I was working on ways to identify market trends using what I called “Risk Ratios.” The idea was to use ratio analysis of major market indices or index ETF products to gauge things like inflation expectations, market valuation, cyclical trends and large-scale short covering. Every Friday, I take time to review these indicators in during my daily session on TheoTrade. One of these indicators I’ve been following closely is on potential short covering that began in early November and has exploded this week.

There are official stats on short interest but it’s hard to get a close look at this on a real-time basis. For the most part, it’s not about the absolute number, but rather the trend. A short squeeze is when those traders who have already sold the stock short, rush to cover their shares by buying the stock. This rush to buy the stock can create large moves in the price.

Risk Ratios Inputs

Relative strength analysis doesn’t give you any indication of whether the price of each component is rising or falling, and Risk Ratios won’t as well. The most important considerations are the inputs and trend of the ratio. Using this concept, the idea is to take two products that are positioned opposite each other. They won’t be negatively correlated because they’re stocks. However, one will typically outperform another in certain circumstances. My short squeeze risk ratio uses the following products:

• Invesco S&P 500 High Beta ETF (NYSEARCA: SPHB)
• Invesco S&P 500 Low Volatility ETF ((NYSEARCA: SPLV)

Risk Ratios: SPHB

This high beta product is a natural when discussing the “risk” part of Risk Ratios. What’s more associated with risk than high beta stocks. Here’s a description from the Invesco website:

“The Invesco S&P 500® High Beta ETF (Fund) is based on the S&P 500® High Beta Index (Index). The Fund will invest at least 90% of its total assets in the securities that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 stocks from the S&P 500® Index with the highest sensitivity to market movements, or beta, over the past 12 months. Beta is a measure of relative risk and is the rate of change of a security's price. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November.”

This product isn’t exactly designed for identifying stocks with high short interest. Nevertheless, the top holdings of the ETF happen to be stocks with high short interest. This makes intuitive sense since highly shorted stocks characteristically have a high degree of volatility.

The image below is a breakdown of the representation in the index by sector.

You’ll notice a heavy representation of the Financials, Energy and Consumer Discretionary sectors. While Financials doesn’t carry a substantial amount of short interest, Energy and many Consumer Discretionary names do. As you drill down into the top holdings, you’ll start to see this.

Risk Ratios: SPHB Components

Let’s dig a little deeper into the top five holdings of the fund to verify the short interest for this Risk Ratio.

• Lincoln National Corp (NYSE: LNC)—5.55% short interest
• Apache Corp (NASDAQ: APA)—5.05% short interest
• Occidental Petroleum Corp (NYSE: OXY)—4.13% short interest
• Carnival Corp (NYSE: CCL)—14.11% short interest
• Haliburton Co (NYSE: HAL)—5.85% short interest

Short interest is measured as a percentage of the float. A value Certainly, you can find more extreme cases, but these companies do generally represent companies that would benefit by a short squeeze.

Risk Ratios: SPLV

Of course, the companion to a high beta product would be low beta or volatility product. Here’s a description from the Invesco website:

“The Invesco S&P 500® Low Volatility ETF (the "Fund") is based on the S&P 500® Low Volatility Index (the "Index"). The Fund will invest at least 90% of its total assets in the securities that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 securities from the S&P 500® Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November.”

As you look at the sector allocation below, you’ll notice that the focus is more on more non-cyclical sectors. This makes intuitive sense given these are the lowest volatility stocks in the S&P 500.

Here is a list of the top holdings for the fund.

As you compare both lists of holdings, you’ll see a large disparity in terms of the types of stocks and realized volatility.

Risk Ratio Analysis: SPHB/SPLV Ratio

As you divide the values of each of these funds, you’ll see which is outperforming. Looking at relative performance would display the return over different periods (weekly monthly, quarterly). However, this doesn’t provide the level of detail that relative strength analysis provides.

As you apply this type of analysis to a chart, the intent is to identify when the trend in the ratio breaks. The use of trend lines is one way to apply this type of analysis.

You can see how trend lines are being applied to identify major breakouts in the chart below. The direction of the breakout would typically reflect more positively (bullish) or negatively (bearish) on the overall market but for high short interest stocks in particular.

Throughout the course of the past year, these breakouts have been a timely warning for bearish and bullish trends. Over the past few week, I’ve been discussing potential rotation into high short interest stocks in my Friday class. This has been especially powerful over the past two weeks.

Conclusion

Using Risk Ratios like this one can be a signal you rely on to signal changes in the trend of the market and rotation into high short interest stocks. This rotation into high short interest stocks can lead to dramatic positive movement when shorts move to cover quickly. Hopefully this gives you a primer into the power ratio analysis can provide.

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