There are too many short sellers

As I’ve discussed previously on this blog, there are many challenges to short selling (see “Do I recommend short selling common stock? No!“).  These problems get worse as more and more short sellers pile into the same stocks.

How much short selling is going on?

By my calculation (based on data from finviz.com), there are 4068 shortable US stocks that trade on major US exchanges.  The total market cap is $21.6 trillion dollars.  Roughly 2.8% of the float is sold short, ignoring the effect of dual listed stocks and short sellers “shorting against the box” (explained to some degree in Cohodes’ colorful court deposition on naked short selling).

On the surface, it seems like 2.8% isn’t much.  But from the short sellers’ perspectives, it’s a lot.  Most short sellers want to beat the market on their short positions.  They can only do this by picking their shorts.  This leads to very crowded shorts.  The following chart shows the distribution of short interest as a % of float:

distribution-of-short-interest

Short sellers clearly aren’t randomly shorting stocks.  They tend to pile into a minority of all available US stocks.  The problem is that the short sellers can sow their own demise.  When they pile into the same heavily shorted stocks, the borrow costs often shoot up to 10%+.  In a few cases it reaches 100%.  These are ridiculous interest rates.  If stocks are supposed to make 6-10% in the long run… then short sellers have to beat the 6-10% hurdle, pay 10%+ interest, and hopefully generate a profit on top of that.

But there’s more.  There other ways in which short sellers can lose money in various forms of short squeezes (sometimes other hedge funds will intentionally create a short squeeze).  Not only do short sellers have to beat the markets, they also have to make sure that they don’t blow up.  Historically, many short selling hedge funds have done the first but now the second (read Richard Sauer’s book Selling America Short).  The history of short selling is pretty brutal and ugly.

Currently, many short selling-only hedge funds are closing up shop.  Despite some short sellers going out of business, there continues to be very high levels of short selling judging by the expensive borrows out there.  This is very frustrating to me as it makes short selling common stock unattractive.  The risk/reward does not look very compelling to me.

The “innovators, imitators, idiots” cycle

This cycle may or may not be playing out.

Whitney Tilson has an “interesting” presentation on short selling.  Here is the slide on “Sources of Good Short Ideas” that I find amusing:

whitney-tilson-slide-LOL

Tilson’s strategy is potentially very dangerous as it is very good at finding crowded trades.  The problem with crowded shorts is that they might all go up at once.  Other market participants may intentionally or unintentionally cause such a short squeeze to occur.  Going long heavily shorted stocks seems to have been a winning strategy in the past few years (Sears, Tesla, homebuilders, Herbalife, Salesforce, Lululemon, Chipotle Mexican Grill, etc.).

In general, I don’t have a problem with plagiarizing others’ short ideas.  However, the important thing is to plagiarize with moderation.  Secondly, it is important to plagiarize good ideas.  ValueInvestorsClub.com is a weird place to look for shorts as many of the best shorts are written up as longs (e.g. Miller Energy, Yukon Nevada / Veris Gold, ATPG, etc.).  In my opinion, the best people to plagiarize from are:

  • Muddy Waters
  • Alfred Little
  • Citron Research
  • Gotham City Research
  • Bronte Capital

But see my disclaimer below.

Stocks I’m afraid of shorting

I’ve largely stopped shorting blatant pump and dumps on OTCBB and Pink Sheets (though I am currently short ACLZ… because I’ve signed up for secfilings.com and see the ads every day).  I’ve been frustrated by the buy-ins on these types of stocks.

I don’t like shorting anything written up by Muddy Waters, Alfred Little, and Gotham.  Many of their reports move markets and instantly attract a huge short selling frenzy where the cost of entry is a ridiculous borrow fee.  Then again, I am currently short AMT, EBIX, TTS, and may very well end up shorting NQ.

My plan going forward

Hopefully I can identify good shorts which have reasonably priced put options.  I am extremely attracted to put options because they don’t have the risk management problems that come with shorting common stock.

I will still short common stock but I will try to be cautious about it.

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2 thoughts on “There are too many short sellers

  1. Interesting post – great thoughts on short selling.

    Could you explain the chart more fully (distr. of short interest as % of float) ? I didn’t quite understand from your description, but it seems potentially interesting.

    Also, “Most short sellers want to beat the market on their short positions. They can only do this by picking their shorts. This leads to very crowded shorts.”

    Why does this necessarily “lead to very crowded shorts”? I don’t see how it necessarily has to.

    • Let’s suppose that everybody practiced Buffett’s “most favored generals” strategy and simply shorted all stocks in equal quantity. There wouldn’t be any crowded shorts as all stocks would have 2.8% of their float short.

      If people start picking their shorts, then some stocks will have more than 2.8% short and others less.

      2- The chart: Each stock is a data point on the chart. They are sorted from lowest to highest short % of float.

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