Blog - Investing Notes

Blog Synthesis: Short Selling and Short Interest

Is short selling activity a useful indicator for investors/traders? Does it mean "stay away" or "squeeze coming"? Here is a listing of past blog entries on the short side of the market:

The Interplay of Short Interest and Institutional Ownership ...short sellers have acted as specialized monitors who tend to know what they are doing, but high levels of and large positive changes in institutional ownership can obscure short interest informativeness.

Implications of Short Selling with No Tick Test ...removal of the tick test for short selling apparently: (1) mitigates overvaluation of stocks; (2) leads to temporary undervaluation of easily borrowed stocks; and, (3) disrupts trading systems that rely on dispersion of analyst earnings forecasts.

Concentrating the Superior Knowledge of Short Sellers ...investors can concentrate the informed signals of short sellers by combining high short interest with low institutional ownership.

Modeling the Logic of Valuation-motivated Short Sellers ...fundamental analysis (especially accrual-related indication of poor earnings quality) helps valuation-motivated short sellers identify stocks likely to experience reversal of strong past returns.

Using Insider Trading to Find Informed Short Sellers ...unusual trading by insiders helps isolate which short sellers know what they are doing, and vice versa.

Shark Attacks? ...it appears that some short selling is manipulative, seeking to scare other traders out of their holdings during sharp but temporary engineered price drops.

Three Questions on Naked Short Selling ...Is naked short selling a problem? The incentives for it seem direct and strong, while both regulation and enforcement against it seem weak. Just getting the facts about its extent is problematic. Here are three relevant questions:

Risky Stocks + Short Sellers = Low Returns ...high short interest alone does not predict abnormally low future returns. Rather, high short interest for stocks that are particularly risky to trade (high idiosyncratic volatility) predicts low future returns. One interpretation is that, when short sellers take on hard-to-hedge positions, they exhibit stock-picking skill.

An Analysis of NFI FTDs: Regulation SHO Fails to Deliver ...the trend in FTDs for NFI is substantially defying the intent of Regulation SHO, and this defiance is depressing the price of NFI stock (by roughly $6 as of 2/3/06). New FTDs most likely come from short sales three trading days in the past, implying that those most responsible for creating the FTDs are not market makers.

Are Some Shorts Smarter Than Others? ...large short sellers generally know what they are doing. A rapid increase in short interest indicates abnormally low returns over the near term.

What Happens to Stocks Going on the Regulation SHO Threshold List? The excess returns of the higher-priced stocks merit some consideration.

Could Failures Point to Success? ...picking through the stocks leaving the threshold lists may be worthwhile.

Short Sellers: Contrarian or Momentum Traders? ...very recent data suggests that short sellers on average are contrarians who predict (or trigger?) near-term stock price underperformance. However, the underperformance is economically insignificant as a statistical indicator due to transaction and carrying costs.

Short Sellers Not So Smart? ...very recent data suggests that short sellers may have lost their ability to predict bad news and stock price declines.

What Makes Shorts Throw in the Towel? ...short sellers throw in the towel (throw more punches) when stock prices move against (with) their positions.

An Engine Driving the Market to a Lower P/E? ...it appears that rapid hedge fund asset growth does indicate a lower market P/E, but the current hedge fund strength may be a typical cyclic event.

The Naked Truth? ...naked short selling is a potentially serious regulatory issue with effects similar to counterfeiting.

Short Kiss of Death? ...underperformance of high short interest stocks may be limited to those with high levels of informed (non-arbitrage, non-noise) trading.

Extra! Short Selling Shocks Stocks ...short selling shocks move stock prices ipso facto. They are news in and of themselves. In the absence of contrary information or reactive strategies, investors should avoid short-shocked stocks.

Buffering Exuberance ...short selling is more effective at buffering exuberance for individual stocks than for the overall market.

Are Short Sellers Smarter Than the Average Bear? ...investors should avoid stocks with high short interest ratios. If you already own a stock that develops sustained high short interest, sell it immediately. You can gamble on squeezes, but on average you won’t win.

In summary, recent research mostly indicates that the average investor should stay away from stocks with high short interest. Playing contrary to short sellers is tricky.