There are very few guarantees when it comes to stock investing. The ever-changing nature of the stock market can make speaking in absolutes a fool’s errand.

However, stock market behavior does repeat itself enough to create some high-probability setups. Recognizing these setups is one of the ways professional investors differentiate themselves — along with the patience to wait for these setups to occur before entering positions.  

#-ad_banner-#One of my favorites among these setups is “fading,” or going against, extreme market moves. This can be done with indicators such as the relative strength index (RSI) and Bollinger bands where extreme readings often signal a change in trend. My favorite “fade” move is buying the most heavily shorted stocks on the market.

These stocks are generally hated by most investors and often have terrible fundamentals that support the heavy short positions. However, not only do many heavily shorted companies possess the potential for a explosive upward move due to a short squeeze, they often outperform the market.

A Goldman Sachs research report last October titled “Investors Focused on the Results of High Short Interest Stocks” found that stocks with high short interest were most likely to outperform during the quarter. The theory behind this is that a high short interest indicates everyone has already sold or shorted shares. If this is the case, the stock is at its low and has nowhere left to go but higher.

Any good news about the company will trigger buying, which in turn attracts more buyers, sending the stock higher. This upward movement, in turn, forces the shorts to cover (meaning they buy back the shorted shares), adding even more fuel to the upward momentum.

When dealing with extreme short interest, I like to take this theory one step further — by finding a stock that is dropping in price along with high short interest. As soon as the stock posts a positive close, I enter a long position with a pre-determined number of shares. While this method may miss the aggressive first move in a short squeeze, the reduced risk is well worth the cost of missing a random short squeeze.  

Under these criteria, the most shorted stock in the S&P 500 is Cliffs Natural Resources (NYSE: CLF). Readers of Dave Forest’s Scarcity & Real Wealth will recognize this firm’s strong investment potential — but right now, a weak commodity market has weighed heavily on the share price.

Cliffs Natural Resources is an iron ore miner with a market cap of $2.9 billion. Shares are down over 20% this year due to a lull in iron ore prices and a drop-off in demand from China. In addition, a proxy battle is taking place between Casablanca Capital, a hedge fund that owns a little over 5% of CLF, and the company’s board of directors.

Casablanca wants to spin off its Bloom Lake project in Canada and its other international assets into a separate company called Cliff’s International. Casablanca asserts this move would enable the company to thrive by turning the U.S.-based assets into an MLP (master limited partnership) capable of doubling its current dividend.  

CLF has a short utilization rate (the proportion of shares available to borrow that are actually being used to short the stock) of 72.6%. The higher the short utilization rate, the more short demand there is for a stock. Compare that with the next highest short utilization rate of 55.3% of Joy Global (NYSE: JOY).     

Shares hit a low in the $18 range March 10. Since this time, price has bounced into the $19 area. Investors who followed the idea of buying on the first up day in a heavily shorted stock would be solidly profitable right now.

Risks to Consider: Buying heavily shorted stocks, even after a positive close, remains very risky. Remember the shares are shorted for a reason and this reason may be very substantial. Although the statistics are positive for buying shares with high short interest, it’s important to note that these numbers are based on a series of trades. Any single trade may or may not perform as expected. Always use stop-loss orders and diversify when investing.

Action to Take –> I am expecting the high short interest to continue to push shares higher in this natural resource company. If you don’t already own shares of CLF, buying a breakout above $19.50 with a nine-month target of $24 makes investment sense right now. Investors with greater risk tolerance can buy now in the $19 area, with stops at $17.50 for both entry levels.

P.S. In a recent issue of his premium Scarcity & Real Wealth advisory, Dave Forest told subscribers about a gold miner that he thinks has fallen too far compared to the price of gold — especially when you consider that it’s one of the top low-cost producers in the sector. Out of fairness to subscribers, I can’t reveal the name of the company here. But to get all the details, click here.