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Cramer explains the explosive combination that signals a raging buy

Jim Cramer decided it was time to arm investors with the same techniques he uses to determine when to buy a stock.

"What I am teaching you are really what I call tells — they are signals that a stock might be worth owning — that it is worth your time and effort to go through the often boring process of reading through the conference call transcripts and quarterly process," the "Mad Money" host said.

Cramer uses the new-high list to determine what should be on his radar. He also looks to buy stocks that have enjoyed a big run or seen substantial insider buying. Insider buying indicates that the people running the company believe the stock will go higher. If they believe in the stock, you should, too.

However, these signals alone are not enough to buy a stock. At the end of the day, you must do the homework on a company. That means checking the fundamentals and making sure the company has a story that you can get behind.

The Priscilla nuclear test, part of Operation Plumbbob. 25th June 1957.
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"This is an explosive combination, and one that often leads to a short squeeze that sends the stock much higher." -Jim Cramer

A stock could also be a raging buy when it has heavy short selling. This refers to when investors borrow shares that they don't own, sell them and then wait for the stock to go lower before buying them back.

Short sellers look to collect the difference between the high price where they sold, and the low price where they buy back the shares. Short-selling is an indication to Cramer that the investor who sold short really believes the stock is headed lower.

"You can think of shorting as like regular investing, only in reverse. We try to buy low and sell high. Shorts just turn that around, selling high and then later buying low," Cramer added.

If a stock has a lot of short sellers, and all of a sudden good news comes out, the stock could surge. That is because the short-sellers then panic and scramble to cover their short positions. This is a move called a "short squeeze".

Even better, when a stock is heavily shorted, sometimes the people who run the company will start to buy shares for themselves. It is the equivalent of management drawing a line in the sand and saying "our stock goes this low, and no lower."

"This is an explosive combination, and one that often leads to a short squeeze that sends the stock much higher," Cramer said.

Usually, short sellers don't know any more about a business than the insiders who run it. So, if a lot of people are shorting a stock and management buys it back in large quantities, this means you need to start doing your homework. That is because you might want to side with management on that one.

When a heavily shorted company announces a huge buyback, bigger than the previous one, that can also give a bullish signal. Management will take this step to stop the short sellers.

Cramer warned that short sellers can seriously damage a stock. So don't just go out there and start buying any old stock with a heavy short balance. One general rule he uses is to buy those stocks that have a large dividend.

This is because when you borrow shares, you are required to pay the owner of the shares the dividend. Therefore, the best protection is to use the dividend as a deterrent from those who abuse short-selling.

"Insider buying plus heavy short interest can equal a raging buy, as long as you avoid situations where the shorts are determined to crush the stock at any cost," Cramer added.


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