Today’sTrading Lesson From TradingMarkets

Editor’s Note:

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
Downloadable 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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