How to Profit on Tax-Based Short-Covering Rallies in 2021

A look at 20 stocks that could benefit greatly from a short squeeze in the new year

Senior Quantitative Analyst
Dec 23, 2020 at 8:00 AM
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If you're looking for short-term trade ideas early in 2021, you'll find this article particularly helpful. Shrewd investors can delay paying taxes on profits by a year if they wait until January to sell off their winners. Similarly, short-sellers who have made money can wait until the new year before covering their shorts. If this phenomenon is prominent enough, then we should be able to identify some short-covering rallies at the beginning of the new year. Below, I am looking to see if the early year short-covering rallies show up in the data. If so, we might be able to find some profitable opportunities early on in 2021.

Evidence for our Theory

Looking at the data over the past couple of years, there is a good case that these short-covering rallies are identifiable. The table below summarizes stocks returns in the first week of 2020. The bolded first column shows data for stocks that were heavily shorted -- at least 10% of their float -- and down more than 10% in the previous year. The assumption is that short sellers had a significant profit at the end of the year on these stocks and many were waiting until the start of 2020 to recognize those profits.

The SPY (SPDR S&P 500 ETF) was up 0.3% in the first week of 2020. While our group of heavily shorted underperformers averaged a small loss over that first week, it was the only group of stocks which had more stocks positive than negative. Also, 52% of these stocks beat the SPY in that first week, while less than half of the stocks of the other groups beat the benchmark.

Stock Returns 2020

The two tables below show similar data for the first week of 2019 and 2018, respectively. For reference, the SPY was up 1.8% in the first week of 2019, and 2.5% in the first week of 2018. In these two previous years, the highly shorted stocks that fell most during the year had beat the S&P 500 benchmark at a higher rate than any of the other groups. Additionally, they also had the highest average return. 

Stock Returns 2019

Stock Returns 2018

Potential Short-Covering Rallies in 2021

I believe the analysis above is good evidence that highly shorted underperformers have an increased chance at rallying in the early part of the next year. Now for the most important part. Below is a list of 20 stocks that are down at least 10% in 2020 with at least 10% of their float sold short. These stocks meet the criteria looked at above for highly shorted, beaten down stocks, that could benefit greatly from early year short covering. Based on the analysis above, these stocks should have a higher probability than normal to increase in the first week of 2021. It is a good stalking list for short-term trades in the first week or so of next year. Additionally, it might be a confirmation indicator for those considering purchasing a technically weak stock.

Early 2020


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