Beat Short Sellers at Their Own Game

03/28/2011 10:53 am EST


Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Short interest data is useful to all traders, particularly contrarians, who can use it to spot unloved equities for potential short-squeeze trade opportunities.

Short interest can be a useful sentiment indicator since it measures the level of investor pessimism toward a given stock. As such, contrarians love to spot uptrending equities that are heavily targeted by the shorts because this signals an ample supply of sideline cash to fuel further gains.

On the other hand, notable short interest can also be a bearish signal. But before we get ahead of ourselves, let's take a step back and start at the beginning.

So, what is short interest? Specifically, short interest is created when an investor sells shares of a stock that he or she has borrowed from a broker, but does not own outright. A basic short-selling strategy is profitable when the price of the shorted stock declines, allowing the investor to repurchase the stock at a lower price in order to replace the borrowed shares. Thus, the short seller hopes—and likely assumes—that the stock he or she has sold short will continue to drop.

Twice a month, brokerage firms are required to report the number of shares that have been shorted in their client accounts. This information is compiled for each security and then released to the public.

By monitoring changes in a stock's short-interest figures, investors are able to gauge the public's level of pessimism toward the stock. Generally speaking, a high volume of short interest indicates that investors have a negative outlook for the company (although heavy short interest can also be created out of arbitrage situations, such as mergers and the release of convertible bonds).

There are two key indicators that are used to measure the level of short interest: The short-interest ratio and short interest as a percentage of a stock's total float.
The short-interest ratio is determined by dividing the total number of shares sold short by a stock's average daily trading volume during a one-month period. The short-interest ratio is a rough estimate of how many days it would take investors to buy back all of their shorted shares at the stock's average daily trading volume.

Meanwhile, the percentage of a stock's total float (or the total number of shares of a company available for trading) that has been dedicated to short selling is another indication of how bearish investors might be. For our purposes, we typically view any readings above 5% as a sign of heavy pessimistic sentiment.

As alluded to earlier, contrarians see this pessimism as bullish for the stock if it is in an uptrend. Why? In the simplest terms, a substantial accumulation of short interest on a particular stock leaves the door open for a potential short-squeeze rally.

This situation typically occurs when an equity suddenly moves sharply higher—perhaps in the wake of a positive earnings surprise, or an analyst upgrade—which forces short sellers to cover (or buy back) their bearish bets in order to minimize the damage. This rush to cover their shorted shares leads to further gains in the security, and in turn, it draws more short sellers into covering their positions.

Yet this kind of short-squeeze situation is not necessary for a bullish investor to reap the benefits of this bearish sentiment. Heavy short interest on a rising stock can help fuel the security's rally as these shorted shares are slowly and steadily unwound in the form of buying pressure.

On a strongly uptrending security, a healthy accumulation of short interest can be thought of as sideline cash should the stock's gains continue.

By Andrea Kramer, contributor, Schaeffer’s Trading Floor Blog

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