Increasing Short Positions Can Be Ominous For Stocks

Shorts are investors, most of them professionals, who bet the price of a stock will go down. To short a stock, an investor sells shares that are on loan from a brokerage firm or other lender. The short-seller eventually must buy the stock in the open market and return it to the lender, known as "short covering." If the stock price declines during this period, the investor books a profit.

This strategy is often too sophisticated or distasteful for the average investor. But would-be bargain hunters might want to take a long look at "short interest," a measure of how many investors are betting against a particular stock.

"It is a very meaningful tool," says Luciano Siracusano, editor of ShortInterest.com (www.shortinterest.com ), an online source for free data about short-selling activity. "In terms of red flags, one of the first things I look for is an increase in the short position."

A large short position suggest a stock is vulnerable to volatility and downward pressure, especially when the company has a relatively small "float," or number of freely traded shares.

Mark Ferreri, who describes himself as a "momentum" investor, says he began visiting ShortInterest.com last month to gather short-selling statistics about stocks he is considering. The 50-year-old software-test engineer says low levels of short interest give him added confidence in a stock's prospects. "It gives a sense that the fundamentals are so good, short sellers don't want to touch it," he says.

Indeed, short investors can be more knowledgeable than average. Because short-selling is a complex and costly trading technique, it tends to weed out less knowledgeable players, says Alexander Butler, an assistant professor of finance at Louisiana State University.

Short interest "is certainly a much better gauge of sentiment than those perennially bullish reports from brokerages," suggests Philip Erlanger, a technical analyst who publishes a newsletter and Web site called Erlanger Short Squeeze (www.erlanger2000.com ).

Recent data show that short interest hit record-breaking levels last month on the New York Stock Exchange and the Nasdaq Stock Market.

On the Big Board, the number of short positions not covered as of Sept. 10 rose 1.3% from the previous month to a record 5.98 billion shares. It was the seventh consecutive monthly high for NYSE short interest and amounted to 1.8% of all shares listed on the exchange, compared with 1.4% a year ago.

Among Nasdaq stocks, short interest as of Sept. 10 reached 4.17 billion shares -- up 2.6% from a month earlier to a fourth-straight record high.

However, some analysts note that short interest is actually below historical averages when measured against trading volume. According to calculations by Mr. Erlanger, the ratio of short interest to volume on the Nasdaq and Big Board are at their lowest point in decades.

Short positions in individual stocks also are meaningful only in context. One such gauge is short interest divided by a company's total shares outstanding, or by its float. Another popular measure is short interest divided by a stock's average daily trading volume, a ratio known as "days to cover," because it approximates how many days of trading would be needed to unwind all existing short positions.

Mr. Siracusano suggests that short interest becomes significant when it amounts to more than 10% of a company's float or when it shows dramatic month-to-month swings.

Some of the most-heavily shorted stocks measured by days to cover include building-materials company USG Corp., auto-parts maker Federal-Mogul Corp. and media group Knight Ridder Inc.

Many financial Web sites provide short-interest statistics, including Yahoo Finance (www.finance.yahoo.com ) and The Wall Street Journal Online, and MSN/CNBC (www.moneycentral.msn.com ).

Historical data about short interest can also be downloaded directly from the Nasdaq at (www.marketdata.nasdaq.com. )

But investors should be careful to understand the limitations of short interest. Statistics about shorting are gathered just once each month, meaning that the data can be weeks old by the time it is made public. The next round of short-interest data from NYSE is scheduled to be released on Oct. 19.

In between those reports, brokerage firms that lend stock to short sellers may have already noticed certain short-selling trends and acted on them.

Mr. Erlanger recommends that investors look for long-term changes in the relative short interest on a stock and compare that with how the stock has performed relative to the overall market. An underperforming stock with a growing short interest can be a bearish sign, he says.

On the other hand, increased short interest on a rising stock could set the stage for more gains if short sellers rush to cover their positions and send the price even higher, Mr. Erlanger says. The phenomenon is known as a "short squeeze."

Indeed, many Wall Street veterans view short selling as a contrarian indicator, meaning that lots of shorting is a good omen. The theory is that short sellers represent pent-up buying power because the shorts will eventually have to purchase shares to cover their positions.

But short squeezes are hard to predict and are less common in bearish markets, some analysts say. "In a bull market, a large short interest would be a contrarian indicator," says Mr. Siracusano of Individual Investor. But in a depressed market, "a growing short position is often a leading indicator of downward price movement."

"Almost all the empirical evidence finds that short interest is a negative indicator," says Mr. Butler of Louisiana State University, who co-authored a study of short-selling behavior between 1995 and 1999.

A few answers: First, on a company-specific basis, high short-interest is a negative as short-interest is "smart-money". ON a market-wide basis, though, high short interest may be a contrary indicator.

On short selling versus options: They are related. A 'synthetic short' can be had by selling a call (a right to buy at price X) and buying a put (a right to sell at price X) at same strike price. If are negative on a stock, instead of shorting you can also buy puts. If stock price falls, the value of the put increases. So options are a way to do leveraged shorting. Commision-wise, shorting is cheaper; but options have more leverage, eg, to short a $50 stock you need $50 margin, but you can buy the put at $50 strike price for only a few dollars (price depends on volatility and other factors).

My bottom line is that shorting was the right thing to do 16 months ago, when the press was talking about buying tech stocks. Consider this article a contrarian indicator. JMHO.

Short seling means you actually sell borrowed shares. You then are obliged to buy those shares to complete the transacion at a later date. If the stock goes down, you win. If the stock goes up, you lose. Options are just that, optional. Say you buy some january 20 options on Disney. If Disney is at 19 come the maturity , you would consider the stock out of the money. You would not be required to buy at 20. You would only be out the cost of the option. If the stock was at 25, you would have the option of buying at 20 and then pocketing the $5 per share profit.

Short selling is the riskier of the two investments as the financial stake is larger. In theory, a stock can rise to an infinite price....

I like the site shortinterest.com but I disagree with how to use the information. Stocks with a massive short interest are exactly the ones you might want to purchase.

If a stock has massive short interest, that means that many people have already sold the stock short and not bought back the stocks to cover their short selling, right?

To me, that would suggest that the 'damage' to the stock price has already been done, and that buying would be a good move since once the stock price inches upward even a little, there's going to be a major demand for the stock as short sellers try to avoid losing their shirts.

On a related note, is there any information on how many of what stocks are owned on margin, and what the margin-call points are? Just as large amounts of stock sold short can cause prices to rise sharply, large amounts of stock bought on margin can cause prices to fall sharply if the stock falls below a margin-call point.

Also, what's the liability situation if a stock which is sold short rises an extreme amount before the broker can sell it, or one which is bought on margin falls an extreme amount? Does the broker have to make up any losses beyond the margin from other commissions, or is the investor liable for funds beyond the amount invested? If the latter, it would seem like options are a much safer bet (since while options have a non-trivial likelihood of becoming totally worthless, that's the worst that can happen to them).

A good trader puts his stop order in immediately after getting confirmation of his position.

That reminds me of two more things I was wondering:

How long do stop orders last, and is there a cost to maintain them?
Is there any information about what stop orders are active at any given time?

It would seem that if a lot of short-sellers have stop orders to buy stock if it hits a certain price to which the market is very close, that would suggest that if the stock hits that price it will go up quickly. Likewise if people who are long have stop orders to sell the stock if it falls to a certain price, that would make the stock drop lower if it hits those threshholds.

"The market was overbought when the gray hairs were buying CSCO. It's oversold when the guy at the butcher shop is shorting GE..."

Heh, heh. You sound like you know the market-- all I know is my stocks. The way I figure it, I don't have a CLUE as to what is going to happen in the world, I don't have a CLUE as to what the market is going to do-- all I know is how to analyze 10 years of 10k's and pick good companies. So, unless something changes in regards to my specific stocks, I'll just sit tight and ride it out.

Actually, what I said above is wrong--I don't think the little guy can ever see a stop order... but you can see limit orders. Usually one will reflect the other. If a ton of people have limits to sell a stock when it's price hits $20, you can bet some people have stop orders at $20 as well.

Perhaps I'm a little confused about the terminology; maybe you can help me out.

My impression was that both stop and limit orders can be used when buying or selling a stock; if the price of a stock is $120 when I place an order with a limit at $125, that means that the broker will try to buy me the stock as quickly as possible, but if it goes over $125 before he actually does so there is no sale and the order becomes void. Likewise it would be possible for me to sell a stock specifying that the sale should not take place if the price falls below a certain threshhold (this would probably be less common, since until the stock rebounds any funds there would be illiquid). Limit orders will not be 'pending' for very long when the market is open, since they will either be executed or voided.

Stop-loss orders, by contrast, wait for conditions to apply which do not apply when the order is actually placed (either for a stock to rise to a certain threshhold before buying, or fall to a certain threshhold before selling). Unlike limit orders, stop-loss orders remain pending until conditions are right for their execution.

I'm a little confused, though, when you say that stop-loss orders can remain in effect indefinitely without cost to the trader. Don't such orders require a certain amount of continuous work on the part of the broker while they're in effect? I'll admit that it's almost certainly automated, but even so it would seem that some resources would be used on an ongoing basis.

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