The Trade: Riding the massive 'short squeeze'

Published Mon, Feb 22 201612:28 PM EST

Dovish Fed remarks and a commodity price rebound have sent investors betting against the stock market scrambling in the last week to cover their shorts, boosting share prices in the process. How should investors position their portfolio amid this massive short squeeze? The S & P 500 is up more than 6 percent from its mid-February low, catching many investors and funds off guard. Commodity prices have risen double digits in a similar time frame, with some heavily shorted commodity-related names such as Freeport-McMoRan and Chesapeake Energy up more than 30 percent during the past week. With the latest NYSE short interest continuing to rise to 15.6 billion shares from 15.4 billion in the previous two-week period, many traders explain how short covering is driving this rally. "A lot of smart money is on the sidelines or positioned bearishly. They may be right intermediate to long term, but in the very short term, their positioning means that there is this tendency for risky assets to squeeze higher on the slightest hint of better news," Michael Block of Rhino Trading Partners said in an email. And when hedge funds start losing money on their shorts, watch out above. "When markets move higher in quick order, as they have recently, the first leg is always short covering. The reason for this is that the most sensitive positions in the marketplace are always shorts since they have unlimited risk," Stuart Frankel's Steve Grasso said in an email. He added, "Long-short hedge funds short positions always hurt more than their longs help on the way up. So when markets rally, funds are forced to cover shorts to limit their losses quicker." Read More The Trade: Stocks that rally on rising inflation Here are the 20 most heavily shorted stocks in the S & P 500 that hedge funds may be de-risking and covering, boosting their share prices in the process. Other investors, however, recommend taking the rally in stride and are skeptical on the fundamentals. "It is becoming clear that the technical short-term structural backdrop for a market rally is in place," JonesTrading's Mike O'Rourke wrote in a note to clients on Feb.17. "That being said, we would caution investors to recognize these (and future) sharp equity market rallies for the simplistic short squeezes they are." Some are even looking to short the market if the ramp continues. "I have been very near-term bullish for the last two weeks, but recommended clients take profits on tactical longs here," BGC Partners' Steve Cortes wrote in an email. "While we believed in a snapback, the fundamentals remain very challenging, PMIs (purchasing managers' index) point to global recession risks. So, I am back to neutral and looking to lean bearishly if the short squeeze persists." Read More Top analyst: Buy this little-known internet stock

A trader works on the floor of the New York Stock Exchange.

Brendan McDermid | Reuters

The is up more than 6 percent from its mid-February low, catching many investors and funds off guard. Commodity prices have risen double digits in a similar time frame, with some heavily shorted commodity-related names such as Freeport-McMoRan and Chesapeake Energy up more than 30 percent during the past week.