Downturn Or Short-Covering Rally? Get A Clue With Short Interest
Short interest can provide a gauge of a stock’s susceptibility to a possible downturn or short-covering rally.
It’s
also one of the most misunderstood statistics among traders and investors.
Each month, the New York Stock Exchange and
the Nasdaq Stock Market report the
short interest on all listed issues after compiling the short positions of their
member brokerages. For
example, let’s say the brokerages collectively have 1 million shares long and 1.5 million
shares short in XYZ Company as of Aug. 15. The stock trades on the Nasdaq Stock
Market. So Nasdaq would
report the 500,000 shares — the aggregate naked short — as the short interest in that
particular stock.
You can look up monthly short interest for individual stocks yourself in such
publications as Investor’s Business Daily or Barron’s. You can
download a text file of the short interest on all Nasdaq stocks from the market’s
Market Data. Then you can use spreadsheet or database software to
search the stocks according to your desired parameters.
Short interest — both for the general market as well as for individual
stocks — is commonly interpreted using what is called the short-interest ratio. The ratio is calculated by dividing the number of shares short by
average daily volume.
Take our example of XYZ Company. Let’s say XYZ’s
average daily volume for the month the short interest was reported stood at
250,000 shares. The short-interest ratio for that stock would be two days — 500,000
shares short divided by average daily volume of 250,000 shares. XYZ has two days’ worth of short interest to cover, assuming a speed limit set by the stock’s
average daily volume.
The New York Stock Exchange Short-Interest
Ratio, a well-known contrarian indicator, works the same way. The ratio is
calculated by dividing the total short interest of all New York stocks
by the average daily volume on the exchange. The ratio is used as
a contrary indicator with extreme high readings coinciding with potentially
excessive bearishness.
As an aside, I glance at the NYSE
Short-Interest Ratio, but I don’t use it. As measures of overall market
sentiment, short-selling yardsticks lost much of their effectiveness in the
1970s and ’80s as options gained in popularity as an instrument for bearish
plays.
In this lesson, I’ll describe how you
can use short interest to evaluate individual stocks that you may be considering
for bearish plays, either by short selling the actual issue or buying put
options.
While important, short interest is a secondary
indicator. I would never short a stock solely on my reading of its
short interest. For more on short-selling tactics, check out Dave Landry’s
lesson, “Shorting
Stocks: The Art Of Playing Both Sides Of the Market,” and Mark Boucher’s
lessons, “Reviewing
The Art Of Short Selling” and “Using
RS Lists to Aggressively Trade on Long and Short Sides.”
In a short sale, a trader hopes to
profit from an expected decline in a stock’s share price. The trader borrows
shares from his or her broker and sells them. If all goes according to plan, the
stock subsequently falls in price, and the trader buys the stock back for less
than the earlier sale price. Buying the stock back is called covering your
short. The trader returns the shares to the brokerage, pocketing the price
difference, minus interest and trading costs, as profit.
What if the stock rises in price? Then
the trader has a paper loss in the stock which becomes a real loss once he or
she covers the short.
Heavy Short
Interest Can Be Bullish
So shares sold short represent shares
that will eventually be bought back. As a result, very large short interest is
a bullish sign for a stock, at least for the near term. If the stock starts to appreciate,
shorts may have to cover. Their buying could drive the share price higher,
forcing still more shorts to cover either to lock in diminishing profits or
staunch growing losses. This is what’s called a short-covering
rally.
The classic short-covering rally
is characterized by a sharp price increase on light volume, but short-covering rallies can occur on heavy trade, as well. As soon as market
makers know they have the shorts on the ropes, they jack up the bids to see how much pain they can inflict.
The media often dubs rallies short-covering rallies when nobody really knows
what’s going on. Often, it’s impossible to tell whether short covering is actually behind
an otherwise unexplained price advance.
The point here is a contrarian one.
Many traders assume that very high levels of short interest is a bearish sign
for a stock. In fact, it’s the exact opposite. All that short interest
represents stock that must eventually be bought back.
“Very high short interest typically means a stock is a long way from a top,” notes Bryan Brown, principal of Spectrum Equity Services, an
institutional adviser based in Beverly Hills, California. “Stocks don’t top on high short interest unless there is something
seriously wrong.”
How much short interest is too much?
There’s no magic number, just rules of thumb. Let’s say I had compiled a list of
shortable stocks using a variety of technical and fundamental criteria. I would
eliminate stocks with short-interest ratios showing more than seven days to
cover.
Expanding Short
Interest Can Be Bearish
Expansions in short
interest in individual stocks are a bearish sign. Again, there are no magic
numbers. But keep your eye out for increases from minimal short interest, say one to
three days to cover in the prior month, to some multiple of that amount. The smart money
tends to move in early on the short side. Once they get their positions on, they
often feed bad news to the financial press.
Beyond seven days to cover, watch out
for short-covering rallies. I would not be interested, for example, in a
short-interest expansion from 10 days to 15. Yes, such a short-interest
expansion could mean the stock is headed for real trouble. But at those levels,
it won’t take much to rattle the shorts and trigger a rally.
A bearish expansion of the short-interest ratio can occur in one of two ways. Obviously, more short selling can occurring
relative to long positions, increasing the short interest in the stock.
Another tactic involves shorting
against the box. Let’s say a deep-pockets player establishes both
long and short positions in a stock. There are a number of reasons for putting
on a paired position. The market participant may have started with a long
position and enjoyed a run-up in share price, then shorted the stock as a hedge.
Or the market participant may be a bear.
In either case, the market participant
decides to bet outright on a price decline in the stock. So the player sells the
long position. Uncovering a big boxed position drives up the naked short
interest. (By the way, notice how this tactic enables a bear to go net short
without waiting for the uptick!)
Arithmetic
Distortion
Every ratio, of course, consists of a
numerator and a denominator. The short-interest ratio consists of short interest
as the numerator and average daily volume as the denominator. So if you use
short-interest figures, be aware that a decline in the denominator (volume) will
inflate the ratio, assuming no offsetting decline in the numerator (short
interest).
Let’s go back to our example of XYZ stock.
In August, Nasdaq reported XYZ had a short interest of 500,000 shares and
average daily volume of 250,000. Imagine that in September, XYZ’s short interest
remained unchanged at 500,000 but average daily volume fell to 125,000. XYZ’s
short-interest ratio would swell to four days to cover. I would disregard the
expansion as any indication of increased bearishness.
Hedging and
Arbitrage
Not everyone shorts on a bearish
forecast. A short position, for example, can hedge a long position during times of
acquisitions. Short sales are also used in convertible arbitrage. “Somebody might short a stock and buy a
convertible preferred in the same company,” Brown said. “One might do that if
one fears inherent risk in the equity
but the yield on the convertible preferred looks particularly good, or the conversion
premium is particularly attractive.”
So once you’ve compiled a list of
stocks with short-interest expansions with days to cover of less than seven, and
you’ve ruled out ratio inflation due to denominator contraction, then check the
wires for news on the stock to rule out the presence of M&A activity.
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