A Review of Short Selling
When you sell X number of stocks that you do not own, but you promise to buy it back in future is called short selling. So how can you sell a stock you do not own ? Basically your broker will lend it to you. Sooner or later you must buy back the same X number of stocks (covering
) and return them back to your broker. When you buy back the stock at the lower price than you sold earlier, you obviously made a profit on the difference. However if the stock price rises, you end up losing money. Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. This is known as being called away.
If there was any dividend distributed, you need to pay it to the lender of the stock. Also because you have loaned the stock, you are buying on margin, which means you will need to pay an interest. Also go through one of my previous articles on The Art of Making Money in the Bear Market.
With the basic knowledge of short selling, let us look at a few important terms/concepts/theories surrounding them, Investors (especially beginners) should thoroughly understand them before beginning their journey in the world of short selling.
A short squeeze can occur when the stock price has risen to a point where short sellers decide to cut their losses and get out. To get out, the short sellers would buy back the stock, which in turn causes an even furthur rise in the stock prices. What this does, is it triggers even more short sellers to get out. This could eventually help the stock price to reach high levels. Short squeezes are more likely to occur in stocks with small market capitalization and small floats.
Traders at times takes advantage of a stock that has been short sold substantially by buying up large blocks of the stock. This causes the stock’s price to increase and forces short sellers to attempt to buy the stock in order to close out their positions and cut their losses. However, because the trader has bought up large blocks of the stock in question, the short sellers may find it very difficult to buy stock at a price that they prefer. The trader can then sell the stock to the desperate short sellers at a higher premium.
Example on Short Squeeze
Say a fictional company Danger Inc is priced around 10$/stock. Say one day due to heavy buying the stock price jumps 20%. Those with short positions may be forced to get out and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price is pushed even higher. This is called short squeeze.
Short interest tells you the total number of shares of a stock that has been shorted and not yet covered by investors. Short interest serves as a good market-sentiment indicator telling you how bearish investors/traders are about the stock. A high short-interest is an indicator that a high percentage of investors are bearish about a stock. This negative sentiment could bring the stock price crashing down. Buying a high short-interest stock should be done with extreme caution. However there are investors who think the exact opposite is true. They believe that if everyone is selling, then the stock is already at its low and can only move up. They are actually bullish on high short-interest stocks because they believe eventually there will be significant upward pressure on the stock’s price as short sellers cover their short positions.
Example on Short-Interest
Let’s assume Danger Inc. has 100 million shares outstanding in the market, with 15 million shares sold short. The short interest on the Danger Inc stock turns out to be 15 million / 100 million = 15%. In short, 15% of all the stocks of Danger Inc in the market as sold short. Now let’s say that Danger Inc. short interest increased by 10% in one month. This means that there was a 10% increase in the amount of people who believe the stock will decrease. What this does is, provides you an alarm to trade with caution. It helps understand market-sentiment to current news related to the company.
The short-interest ratio is the number of shares sold short divided by average daily volume. This ratio tells you how many days it will take short sellers to cover their positions. The higher the ratio, the longer it will take to buy cover. Saavy investors/traders use this important ratio to decide whether to take a short position on the stock. Typically, if the days to cover stretch past 8 days, covering a short position could prove difficult.
Example on Short-Interest Ratio
Let’s assume 15 million shares of Danger Inc are sold short, and the average daily volume of shares traded is 5 million. The short-interest ratio in this case turns out to be 3, indicating it would take 3 days for all of the short sellers to cover their positions which sounds like a reasonable time.
The NYSE Short-Interest Ratio
The NYSE short-interest ratio is another great metric used to determine the sentiment of the overall market. The NYSE short-interest ratio is the same as short interest except it is calculated as monthly short interest on the entire exchange divided by the average daily volume of the NYSE for the last month.
Example on the NYSE Short-Interest Ratio
Say there are 5 billion shares sold short in May and the average daily volume on the NYSE for the same period is 1 billion shares/day. This gives us a NYSE short-interest ratio of 5 (5 billion /1 billion). This means that, on average, it will take 5 days to cover the entire short position on the NYSE. In theory a higher NYSE short-interest ratio indicates a more bearish sentiment towards the exchange.
Conclusion: With the knowledge of short selling, you have added another trading technique to your toolbox. Additionally with the knowledge of short squeeze, short-interest and short-interest ratio, helps make an informed short selling decision. However short selling can be very risky and you should proceed with extreme caution. Short selling is especially not recommended for investors beginning their journey at the stock market.