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"Betting Against Shorts Isn't Wise"

 
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PostPosted: Fri Nov 25, 2005 2:51 pm    Post subject: "Betting Against Shorts Isn't Wise" Reply with quote

USATODAY.com
Betting against shorts isn't wise
Thursday November 24, 9:03 pm ET

On Wall Street, short interest means more than an unusual curiosity about leprechauns. It refers to the volume of betting that a stock will fall.
Conventional wisdom says that you should buy stocks with huge amounts of short interest. Unfortunately, conventional wisdom is wrong. You're often better off avoiding stocks with lots of short interest.

When you sell short, you borrow shares from your broker and sell them on the open market. To close the deal, you buy the shares back. It's the opposite of a typical stock purchase, called a long position.

Let's say you noticed that the price of moose antlers was soaring - which, in turn, would hurt the earnings of Amalgamated Hatrack. You decide to go short, so you borrow 100 shares of Amalgamated Hatrack from your broker and sell them at $30 per share.

Two months later, Amalgamated Hatrack falls to $25. You buy the shares back and pocket the $5 difference per share, for a $500 profit.

Selling short isn't for the fainthearted. Suppose the company introduces a new line of hatracks using artificial moose antlers. Even worse, these hatracks are featured on Trading Spaces. The stock soars to $40. When you buy back the shares - called covering - you have lost $10 per share, or $1,000, plus commissions.

Short selling has other drawbacks. It's a margin transaction, so you have to pay interest on the amount you borrow from your broker. Dividends count against you. Stocks tend to go up more than they go down. And the most a stock can fall is 100%. If you short a stock and you're wrong, there's no limit to how high the stock can go - and how much you can lose.

The latter item makes short interest an interesting statistic indeed. When many people have sold a stock short, sooner or later they have to buy back the stock to close the trade.

Daniel Drew, a famous 19th-century bear, even made up a little ditty about it:

"He who sells what isn't his'n

Must buy it back or go to pris'n."

You probably won't go to prison on a sour short, but it might seem like a better option. If a stock with a great deal of short interest soars, it creates a short squeeze. Investors scramble to buy shares at any price to close their short position. That, in turn, sends the price soaring more.

The possibility of a short squeeze is one reason some analysts look at a high amount of short interest as a bullish indicator. If you assume that the majority of market participants tend to be wrong, then lots of short interest must be bullish. And if the shorts are wrong, there's a possibility of a short squeeze - a happy event if you own the stock.

All good in theory, but not in practice, says Richard Gates, portfolio manager at TFS Capital in West Chester, Pa. "The more short interest there is in a stock, the more bearish you should be," he says.

His reasoning: Most people don't short stocks. Those who do tend to be Wall Street professionals, and they tend to be fairly savvy investors. "If someone is shorting a stock, they'd better have good reason to do that," says Chao Chen, director of analysis at TFS.

Several academic studies have thrown cold water on the notion that it's a good idea to buy heavily shorted stocks. TFS' research on small-company stocks suggests the same thing. From 1995 through September 2005, the most highly shorted stocks returned, on average, 0.6% the following month. Those with the least short interest gained 2.3%.

Interestingly, stocks with the most short interest didn't even fall much: They just kind of lay there. The best advice for a stock with lots of short interest is that you should probably leave it alone. "It's a sanity check," Chen says.

You can get some useful information from short interest if you use it in conjunction with other information, argues Dylan Wetherill, president of ShortSqueeze.com. A basic tool: Look at the number of days it would take to cover all a stock's short interest at its average daily volume. The more days it takes to cover the shorts, the heavier the betting against the stock.

General Electric, for example, has more than 60 million shares short. That's about three day's volume for GE. Allied Waste has 43 million shares short, but it would take 33 days to cover all of it. Clearly, investors are more bearish on Allied Waste than GE.

Combine performance with short interest, and you could have a good indicator, Wetherill says. A stock with lots of short interest that's reaching new 52-week highs could be a candidate for a short squeeze and therefore a good buy.

"Short interest is a fuel," Wetherill says. "Performance is the fuse."

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com
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