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 your homework on the company. That means checking the fundamentals and making sure the company has a story that you can get behind.
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A stock could also be a raging buy when it is subject to heavy short selling, or when investors borrow shares that they do not 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 investors who sold short really believe 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 panic and scramble to cover their short positions in a move called a "short squeeze."
Better yet, 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, you need to start doing your homework because you might want to side with management on that one.
When a heavily-shorted company announces a huge buyback, bigger than previous ones, that can also send a bullish signal. Management can take this step to stop short sellers.
Cramer warned that short sellers can seriously damage a stock, so do not haphazardly start buying any old stock with a heavy short balance. One general rule the "Mad Money" host uses is to buy those stocks that also have large dividends.
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 concluded.
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