I’ve gotten a few questions recently about investors who are concerned about short selling and the impact on stocks. That’s not surprising as people get nervous when the market gets a little shaky.
It’s a good question to consider, and I do view stocks with a high short interest differently.
Let’s start with “Shorting 101.” Short selling is when a trader “borrows” shares from a brokerage firm. They then sell the stock — or “short” it — in the hopes that the stock will go down, at which point they buy back the shares and return them to their broker. They keep the difference as their profit.
For example, say you borrow shares of XYZ at $100 and the stock drops. You buy the shares back at $75, return them to your broker and keep the $25 difference as your profit.
For the most part, shorts are professional investors that are well-armed in the sense that they have a lot of information and they have patience – plenty of it. Short-sellers often wait a long time for a stock to crumble. That’s what makes them tough, and it can be dangerous to bet against them.
Short positions can become somewhat self-fulfilling due to the amount of pressure short selling puts on companies. I’ve noticed that lately we’ve seen a lot of short-sellers act as a sort of Captain Ahab and seek to destroy a company, whether their information is right or wrong. They are no longer only betting that a stock will go down, some are trying to make sure the company goes out of business altogether.
I find it interesting that of the 21 most shorted stocks on the market right now, one third — or 33% — have been beaten down to 52-week lows. That proves how relentless these short-traders can be.
When you see a large short position on a stock — I tend to look for short interest in the double digits or higher — it tells you that Wall Street is banking on that stock crashing, whether it is because of the company itself, its industry or the broader market. While that doesn’t always happen, large short positions tend to make the everyday investor uneasy.
So what should you make of stocks with large short positions?
Seeing a large short position in a stock certainly doesn’t attract me to it, but it doesn’t push me away from it either. I look at a company’s fundamentals and determine whether that short position is justified.
If I don’t believe it is and decide to buy the stock, I do tend to be a bit more cautious when it comes time to cashing out. I’ll often take my winnings off the table sooner than I would in a position that doesn’t have a large short position.
In addition, there is something called a “short squeeze” that can send a stock higher. When a stock starts moving in an upward trend, the shorts see their losses starting to mount, so they buy back the shares to return them to the broker and “cover” their position. If a lot of short-sellers decide to cover and start buying shares, it can create its own updraft for the stock.
Now, I never recommend buying a stock for the sole purpose of benefiting from a short squeeze. However, there can be times when a squeeze works out in our favor. For example, I talked about a nice profit I made thanks to a short squeeze in a previous Smart Talk article.
When you see a stock with high short interest, it’s important to understand what you’re getting yourself into. You don’t want to get stuck on the wrong side of the bet.
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