For many investors, the idea of short selling shares not only raises questions about how the mechanics of such trading actually works but also conjures the unpalatable prospect of sustaining heavy losses should it all go wrong. But that doesn’t mean it’s a bad thing to study companies in the market that have the dubious honour of having high levels of ‘short interest’. In fact, because short sellers tend to be very, very smart investors, examining their trades can provide a crucial insight into which shares you probably ought to dump from your portfolio.
Short selling as an indicator
With the exception of the occasional headline in the financial press, the strategies that drive the short selling activities of boutique hedge funds and large investment banks are generally not well known. But research suggests that these smart money managers are some of the most informed investors around, skilled at processing information and adept at identifying future events that will negatively impact on share prices. After all, borrowing stock from an institutional holder (via a broker) and then selling it in the market with the expectation that its value will fall, is one that comes with theoretically limitless financial risk. If the stock actually rises and the trade has to be reversed, the short seller may need deep pockets, a strong appetite for risk and a potentially long investment horizon before the bet comes good - clearly this isn’t a game for widows and orphans!
Unsurprisingly, academics have spent years examining the impact of short selling and many agree that an anomaly exists whereby heavily shorted stocks often fall in price. Not only that, but a stock that is being short sold can act like a magnet to other short sellers, who join the trade and push the price down further. Researchers have concluded that this anomaly is driven by a perception among other investors that short sellers are actually rather good stock pickers.
Finding short interest
But while an anomaly plainly exists, any investor wanting to act on it needs to do their homework to properly understand which shares have the highest levels of short interest. Unfortunately, simply perusing the FCA’s regularly updated list of short selling positions won’t cut it. Not only is it necessary to identify high percentage short interests, but investors also need to put that in the context of shares outstanding in a given company and…
