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The Power Of Short Covering

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Last Monday, I wrote about a peculiar pattern in Autozone (NYSE:AZO). The stock traced what I refer to as an ascending wedge, although other market technicians may refer to the pattern as a triangle, pennant, or flag. I don't care what you label a pattern. The importance is in recognizing the pattern and discerning what it's revealing about supply and demand.

Over several weeks, AZO traced a series of sequentially higher lows, but was unable to break above the $68 level. I used this chart last week:

A few days after I profiled the stock, the company reported quarterly figures that surpassed estimates by a wide margin. The company reported same store sales growth of nine percent for the quarter. On the bottom-line, Autozone reported earnings of 76 cents per share, which blew away the 60 cent consensus estimate. The stock blew up the day after it reported. Hopefully you were in it, because I wasn't.

The stock was higher by about $12.50 following its report. In other words, AZO broke out. I couldn't figure out why the stock was higher by almost 20 percent after its positive report. Does that sound contradictory?

Sure, the report was bullish. But did it warrant a 20 percent pop? In my estimation, most of the good news had already been discounted. After all, shares of Autozone are higher by about 175 percent this year, which makes the stock the second best performing component of the S&P 500.

Upon further investigation, I discovered why the stock popped by about 20 percent. AZO had been heavily shorted into its earnings report. More than 6 million shares of the stock had been shorted, which potentially explains why it wasn't able to clear the $68 level prior to its report. The shorts could've "leaned" on the stock at $68.

It is beyond me why anybody would short AZO when the stock has been so very strong. But short they did. And when the company reported its bullish quarter, the shorts panicked. I can imagine the call to the broker went something like this last Wednesday morning:

"[Expletive deleted], cover my AZO."

The broker replied, "At what price?"

"I don't care," answered the short, "just get me out."

Thus the 20 percent pop in AZO last week.

Now, you might be thinking to yourself that I'm going over the AZO example to boost my ego. That by pointing out the wedge last week, I somehow "called" the breakout. But that entire notion is the farthest from the truth. I didn't trade it. That was obviously a mistake. But I like to learn from my mistakes and in doing so, hope to help you make money.

Since I missed the AZO trade, I've been searching for similar situations and I think I've found one in XM Satellite Radio (NASDAQ:XMSR). Jeff Bailey's been writing about this stock and it was recently added to Option Investor's call play list. (It's amazing how great minds think alike.)

XMSR and AZO couldn't be more different. I can walk into the local Autozone to check the store, speak with the manager, and get a tangible feel of the business, all of which I've done recently. I don't have the resources to do the same with XMSR. Plus, XMSR is in a developmental stage, unprofitable, and carries debt.

But the price action of XMSR recently is similar to what I observed in AZO last week. And a lot of XMSR has been sold short. The most recent data reveals some 10 million shares have been shorted. That's more than 25 percent of the stock's float!

Like AZO, XMSR has traced an ascending wedge over the last several weeks. Unlike AZO, XMSR's wedge is more aggressive and the stock has already broken above the upper-end of the range at $13.00.

I don't know if the XMSR breakout will end like the AZO move. There are innumerable variables that go into each move in the market. But, in the right market environment, the XMSR pattern may work in similar fashion to AZO. The XMSR pattern is similar to AZO in that the lows are tracing higher and there's a large short position in XMSR, too.

Short covering can be a powerful force when the stars align. The alignment can come in the form of higher bond yields, a breakout in the tech space, and an overall advancing market. If those aforementioned events occur, look for the shorts to panic in XMSR.

Eric Utley
Option Investor

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