WHEN THE PUBLIC is in the market, they’re always long the market, and during those periods when the market falls, the masses invariably go looking for someone to blame. Because they appear to profit at the public’s expense, no scapegoat is more popular, or unfairly vilified, than the short seller.
It’s almost as if one of the freedoms inherent in a capitalist democracy, specifically the ability to buy stocks we feel are due to rise and sell those we feel are due to fall, isn’t extended to short sellers. Their activities are often characterized as immoral, unethical and downright un-American.
For a long time, of course, they were just downright unprofitable. During the mid- and late-1990s, short sellers like Manuel Asensio or bears like Jim Grant were seen as old-fashioned heretics, steadfastly refusing to accept the fact that we were in a new paradigm where historical oddities like interest rates or valuation no longer mattered. The fact that the shorts were losing hundreds of millions of dollars as the market rocketed higher didn’t seem to bother anyone. After all, it was their poor judgment to bet against the market to begin with. Indeed, guys like Charles Allmon, Robert Prechter and David Tice were frumpy, charming leftovers from a bygone era that, until last year’s precipitous decline, seemed as if it would never return.
But these days, with short sellers reaping huge profits from declining markets, they have become Public Enemy No. 2. A cursory scan of the popular message boards will yield more than a few examples of antishort sentiment.
And the scorn doesn’t come just from the grass-roots investor. Last April, for example, MicroStrategy (MSTR) Chief Executive Michael J. Saylor wrote a letter to stockholders blaming short sellers for the huge decline in his company’s stock price, which had fallen from $332 in March of 2000, to just over $2 a share. Of course it was the short sellers! The company’s accounting irregularities or huge losses certainly had nothing to do with the stock’s astonishing decline.
Politicians also love to denounce the shorts. In 1997, Malaysian Prime Minister Mahathir Mohamad accused short-selling hedge funds of precipitating the collapse of Asian currencies.
Recently, even some U.S. lawmakers have gotten into the act. In the wake of the Sept. 11 attacks, Rep. John LaFalce (D., N.Y.) asked regulators to consider a temporary halt on short selling. In a letter to Securities and Exchange Commission Chairman Harvey Pitt, LaFalce wrote, “To the extent that short sellers have played a significant role in creating the current market conditions, I request that you consider the appropriateness of certain measures, including inhibiting short selling.”
While this recommendation thankfully hasn’t been heeded, it displays an ignorance unbefitting any investor, let alone the ranking member of the House Financial Services Committee. The fact is that short sellers don’t cause the market to fall, but to rise, as a brief overview of the mechanics of short selling makes it clear.
We’re all quite familiar with going long a stock, or buying in anticipation of a rise that would allow you to sell later at a profit. Selling short is just the opposite. It is, quite simply, betting that a stock will decline in price.
While selling short seems complicated, the mechanics are rather simple. The short sells first, hoping to buy later at a lower cost. So when you sell 100 shares of XYZ short, your broker borrows the shares from another account and sells them in the open market on your behalf.
Essentially, it’s “buy low, sell high” in reverse. If the stock declines, the short seller is able to replace the borrowed shares at a lower price and earn the difference. If the stock rises, the short is forced to repurchase the stock at a higher price than he sold it for, netting a loss. What makes short selling an inherently high-risk strategy is that while its profit potential is limited, its loss potential isn’t. After all, if you buy a stock long, the most you can lose is your initial investment. A stock can fall only to zero. But short sellers face potentially unlimited losses, because a stock can theoretically go up indefinitely, and, unlike the longs, shorts must eventually cover their bets by buying back whatever stock they have sold short.
This is precisely what politicians, journalists and even most investors don’t understand about short selling. Despite its negative connotations, a high level of short selling is a bullish indicator. Both individual stocks and the overall market are strengthened when short selling rises because those shares sold short must eventually be covered — or bought back. Long stockholders, those prudent and tempered patriots who buy stock for the long haul, are actually just sellers in waiting, while shorts are buyers to be.
Therefore, short interest isn’t a measure of selling pressure — but buying pressure. Like the VIX, fund flows or other components of sentiment analysis, short selling is a contrary indicator.
Aggregate short selling is measured by tallying the short interest, or the number of shares that have been sold short and are yet to be covered. The higher the short interest, the more people are betting on lower prices…and the greater chance the market will rally.
Given recent trends, there are reasons for short-term optimism. The most recent report from the New York Stock Exchange shows that a record 5.98 billion shares have been sold short, over 1.8% of the total shares listed on the exchange. (See the bar graph above.)
Nasdaq short interest has also been at historically high levels. In September, it rose to over four billion shares, hitting a record for the fourth straight month in a row. If history is any guide, this is a bullish sign.
Because the indexes are so large, I’ve always found short interest to be most helpful when analyzing a particular stock. The best way to do so is to calculate the short-interest ratio, which is simply the number of shares sold short divided by the stock’s average daily volume.
For example, if the company trades an average of five million shares a day and the current short interest is five million shares, then the ratio is 1.0. Often referred to as “days to cover,” it gives a rough estimation of how many days it would take to buy back all outstanding short sales based on the stock’s average daily volume. Short-interest information is available on the stock-screening tool of SmartMoneySelect, some specialized Web sites and those of most major exchanges.
Historically, positive price action coupled with a short-interest ratio near or above 2.0 have been an indicator that a short-term bounce is probably imminent.
But you should also note that since many shares are sold short as part of complex options strategies, traders can’t rely solely on the short ratio to isolate opportunities. As with most tools in technical analysis, it’s best used in combination with other indicators.
When the market falls, the blame game begins. Some pick on the Fed, others harp on hedge funds. The biggest, and most undeserved, criticism is heaped on the shorts — who, like the rest of us, are entitled to express their opinions in a free marketplace. Contrary to popular belief, they don’t make the market drop, but rather stabilize its fall — an important point lost on most of the so-called experts who denounce them.
– Originally on Oct 09, 2001 by Jonathan Hoenig
