There are strategies available to investors that can help turn a profit even when the bear comes knocking. One such strategy is called short selling.
When a stock is sold short, it means that an investor has sold the stock that he does not own. To do this, the investor needs to borrow the stock from his broker, sell it in the open market, and pay for the transactional and borrowing costs.
The investor’s bet is that the market price will fall below the price at which the investor had short-sold the stock. And the difference between the short sale price and the price the investor bought the stock back is his gross profit. To arrive to net profit, what must be deducted are all transactional and borrowing costs.
Of course, short selling is not a bulletproof strategy. There is always the possibility that the stock price will increase. As a result, buying back at higher prices will create a loss and deflate the strategy. On top of that, at least theoretically, that loss could be unlimited, which is why investors would be wise to utilize stop limits.
Short interest could be compared to a barometer of sorts. It is usually expressed in percentage terms (although it can also be a number of shorted shares) and it tells investors how many shares of a stock have been sold short without being bought back yet. More importantly, knowing that percentage can help weigh in market sentiment towards a particular stock.
Short interest is usually calculated at month’s end, so what investors need to watch for are month-to-month fluctuations in these percentages. If, for example, there is a large increase this month compared to the previous month, chances are that investor sentiment has turned against the stock. Typically, there is disappointing news or a lawsuit, suggesting that there is something wrong with the company, scaring investors away from it.
A word of caution! Short sellers have been wrong in the past. They have also been known to “overact” from time to time, for lack of the better word. So, take the short interest figure with a grain of salt, or view it within the underlying context.
Aside from the month-month short interest, there is also something called the days-to-cover ratio. This ratio tells us how many days are needed for open short sellers to cover their positions in case the market turns against them.
For example, let’s assume that a company has a short interest of 65 million shares and that on any given day about 60 million shares changes hands. This means that if all short sellers wanted to cover their short positions, it would take them about 1.08 days. For obvious reasons, the ideal days-to-cover ratio should be as low as possible because the last thing any short seller wants to experience is the short squeeze.
When a stock moves against a short seller (when the price is surging), the gut reaction is to cover the short as soon as possible. Only, this is exactly how everyone else will feel too. So, when short sellers join the stampede and start buying back as many shares as there are available, the stock price surges and short sellers find themselves in a squeeze.
Bear in mind that having a high short interest does not necessarily mean the writing is on the wall for a company. There is always a possibility that short sellers could be forced to cover before their trades have full developed. On the other hand, it is also possible that a company is drowning in the deep end. To distinguish between the two, investors need to analyze other factors relevant to the company’s financial performance.