A run-down on shorting stocks, short squeeze and short interest

Equities can be traded in several ways with two of the most common being long (buying) or short (selling) the actual stock. Holding a long position means investors gain when the stock price goes up and lose when it goes down. Holding a short position is the opposite.  So, whether you believe a certain stock price will move up or down, you can make a trade based on your view.

What happens when you sell a stock short?
When an investor shorts a stock of a company, he sells the stock that he does not currently own. He therefore borrows the shares from another investor and then sells the stock into the market, thereby receiving proceeds from the short sale. When the short seller decides to close out his position, he will buy the stock at the prevailing market price. When he buys back the stock the short seller is therefore hoping that the price has dropped from the time of his original short sell. The difference between the selling price and the buy price is the short seller’s profit, the reverse of a long position.

As a simple example, an investor borrows and sells short 10 shares at the price of $100 on a Monday, for proceeds $1,000 which he receives. On the next day the price has dropped to $75, and the shorting investor decides to close his position and buys back 10 shares, at the total cost of $750. Therefore the shorting investor has gained $250 (1,000 – 750). Should the stock price rise between the date of shorting and date of returning the shares, the investor will need to buy the shares to return at a higher price, resulting in a loss in his books.

Risks and costs of shorting stocks
Because shorting occurs in a margin account, investors usually have to post collateral for the short sale. Because the stock is borrowed through the broker, the short seller must pay monthly interest to the broker.  In addition to the interest cost, a short seller will have to pay for any dividends that the stock pays to the holder of the shares.

In addition to the financing and dividend costs, short sellers face an unusual risk profile. Because a stock can theoretically increase forever but cannot go below zero, a short seller faces unlimited risk and limited benefits.

What is a short squeeze?
In a few words, Investopedia defines short squeeze as ‘a situation in which a lack of supply and excess demand for a traded stock forces the price upward’.

If a stock has a considerable amount of its shares being sold short, it can become subject to a short squeeze. With a stock price rising rapidly, more and more investors who have sold the stock short are likely to close their position, or simply be forced to liquidate their positions due to lack of collateral. If the stock is being heavily shorted, the increase in price can cause traders to rush to ‘cover’ their short positions by buying the stock to offset their positions, thereby potentially sending the share price quickly higher. Short squeezes typically occur in smaller companies that have smaller floats.

Short interest and why it is interesting
Short interest is the total number of shares of a certain stock that have been sold short by investors. Short interest can either be presented as number of shares or as a percentage (usually percentage of floating shares) and is normally shown monthly by the corresponding exchanges.

As an example, the chart above provides the short interest on popular stocks.  One of them is Facebook which has 552.9m shares floating (available for trading) on the stock exchange. Of these shares, 61.3m have been borrowed and sold short, corresponding to 11.1 percent of the traded stocks.

For equity investors it is interesting to see how many shares of the stock have been borrowed for short selling at a certain point in time. Stocks that have a high short interest can become subject to a short squeeze (see in detail below), creating an exaggerated upward move in the stock price.

Contrarians often look at a stock’s high short interest percentage as a way to determine the sentiment of the market regarding the stock. A high short interest might signal to a contrarian investor that there is too much pessimism regarding the stock and that it might be oversold, making it a good buy opportunity.

Furthermore it is interesting for investors to follow the development of short interest over time. Large changes in short interest within a certain time frame can be interpreted as a change in investor sentiment. If a higher proportion of a stock’s float is borrowed for short selling, it signals that investors increasingly expect that the stock price will decrease, and vice versa.

This does not mean investors should jump on the ‘short selling wagon’ solely based on short interests. Those bearish short selling investors could simply be wrong! Therefore, you should always stick to your due diligence and merely use short interest as one of many indicators in the market.