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Let's Play Opposites

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August 1, 2014
Let's Play Opposites

Buy low, sell high—so goes the ridiculously oversimplified mantra for all things markets. Now, flip the order of that sentence, and you’ve got the essence of shortselling. Scary? Perhaps. But understanding a few things about why short sellers do what they do might provide some valuable investing insight.

Investors have long been conditioned to seek out things that go up in price—for good reason, of course. Shares of companies with solid management and profit growth are often good places to park your money. But short sellers think differently. They’re contrarians and grave-dancers, swimming against the tide, tilting at windmills, and effectively wagering against stocks they believe are heading for a nosedive. It’s a complicated and risky practice, and the shorts aren’t always right. When they’re wrong, it can get ugly for them very quickly.

To be sure, short selling is the domain of nimble, seasoned professionals—hedge funds and others with large amounts of capital and the capacity to absorb losses when the market moves against them. Still, for the traditional equity investor, there are several good reasons to keep an eye on what short sellers are doing as a group to stocks and/or the market. Short interest “is something we follow very closely,” said Joe Bell, Senior Equity Analyst at Schaeffer’s Investment Research. “When a stock has high short interest, it means that there are a lot of investors expecting that stock to decline.”

So, grab your shorts and consider the following.

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FIGURE 1: SHORT CUTS. Short interest as a percentage of the float (i.e., outstanding shares) is available for specific stocks under the Research & Ideas tab (red circle) on tdameritrade.com. For the stock in this example, short interest accounts for about 2.2% o outstanding shares (red arrows). Source: TD Ameritrade. For illustrative purposes only.

Names Make News

Data on short interest—that is, the number of shares outstanding that have been sold short—is available for most U.S. companies listed on major exchanges. The New York Stock Exchange releases a short interest rundown every two weeks. A glance at these reports usually reveals some familiar names—say, a troubled retailer or electronics maker that’s found itself in the crosshairs of short sellers.

There are often interesting stories going on here. Do you see any stocks you’re considering as investments, or that are currently in your portfolio? Think about why other people in the market may have an opposing viewpoint. Check recent earnings reports or listen to conference calls for clues and color on real-world events that may have implications for shareholders. Short interest readings are also available when you log in to your account on tdameritrade.com (see figure 1).

“When following short interest indicators, it’s critical to understand the context of a company’s fundamentals,” said Eric Utley, Manager, Curriculum Development, with Investools®, the education affiliate of TD Ameritrade. Factors to keep in mind include the recent performance of the stock and the potential for a “binary event,” such as a government ruling on a new drug, he said.

Float On

Market pros follow a few key metrics, including shorts as a percentage of float, which reflects the number of short-sold shares in proportion to the float, or the total number of shares available for trading in the public markets. Most stocks have a small amount of short interest, usually in the single digits. The higher that percentage goes, typically the greater the bearish sentiment surrounding that stock.

Take a closer look when the short float is 10% o higher, Bell said: This is usually the sign of a concentrated short position and can be a sign of a fundamental problem with a company or set the stage for a short covering rally. Some of the most heavily shorted NYSE stocks are at 30% o higher.

Something else to watch is days to cover, also referred to as the short interest ratio. This indicates how long it would take to cover, or buy back, all the shorted shares, and is calculated by dividing the number of shares sold short by the average daily trading volume. This can be viewed as a measure of the future buying pressure on a stock, since short sellers must eventually close out their positions. Typically, short sellers like to see around seven days to cover or fewer.

Squeeze Play

That brings us to the bane of the short sellerthe squeeze. This can happen when a piece of bullish news comes along, pushing the stock price higher and prompting the shorts to run for the exits en masse. As the shorts scramble to buy back and cover losses, upward momentum builds upon itself and the stock can move sharply higher. The longer the days to cover, the more pronounced this effect can be.

Some short sellers try to sell stocks into strength, which is generally a mistake, Utley said. In fact, increasing short interest coincident to a trending-higher stock price can sometimes be a good indicator of further gains in the stock, all else being equal.

Short interest can also be applied alongside chart indicators, such as moving averages, for signals on when it may be time to get out of a stock. For example, a combination of high short interest and a drop below the 52- week low or the 200-day moving average might say look out below.

These are stocks that sometimes go on to drop by a considerable amount because the high short interest and poor performance usually act as confirmation, Bell said.

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FIGURE 2: LONG AND SHORT OF IT. Short interest in S&P 500 Index companies (red line) surged to more than 19 billion shares during the 200809 financial crisis; more recently, short interest declined as the market climbed to all-time highs. Source: Schaeffers Investment Research For illustrative purposes only.

The Big Picture

Short selling can also offer some context for the broader market. In the throes of the 200809 financial crisis, short interest soared as stocks plunged (see figure 2). More recently, as the Standard & Poors 500 Index and other U.S. benchmarks rose to record highs in recent months, overall short interest edged lower, suggesting that market bears are fighting the tide less and less. At the end of July, short interest in S&P 500 stocks was 2.29% o shares outstanding, near a 16-month low of 2.16% rached in May, according to FactSet Research Systems.

Last spring, total NYSE short interest stood around 14 billion shares (34% o shares outstanding), in the middle of the range for the past few years. This says to me that shorts are balanced in their collective view on the market and arent anticipating a significant decline anytime soon, Utley said. At the same time, there appears to be limited potential for any sort of short squeeze that might further fuel gains. There arent enough scared shorts in the market, Utley added.

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