In my experience, the cost to borrow shares is a far more powerful predictor than short interest. Anybody who looks at short interest instead of the cost of borrow is probably not that savvy.
The cost of borrowing shares is dependent on the supply and demand of shares being lent out. Supply shortages can occur for reasons such as:
- Almost all the stock is owned by retail investors, who rarely lend their shares out.
- Parties intentionally trying to disrupt the borrow. For example, the CEO may write a letter to shareholders encouraging them to put their shares in a cash account (where they cannot be lent out to short sellers).
- Savvier market participants and Jim Cramer-types try to engineer buy-ins on the shorts by suddenly putting their shares into cash accounts. (Yes, I do think that Jim Cramer knows how to generate alpha.)
If there is more demand than supply, then buy-ins will occur for the shorts. The short sellers are forced to cover their positions; they don’t have a choice about this.
Short interest is often a poor metric because the % of the float available for lending varies widely. For obvious pump and dumps (e.g. you receive their pump emails in your inbox), the float is often owned by retail investors and there is extreme competition for the borrow. The short interest may be low because there are very few shares available for borrowing. However, the chances of buy-ins and short squeezes may be extremely high because the borrowing capacity is being used up (causing the borrow to be very expensive).
If the cost of borrow is expensive (e.g. 10-200%+), then there will be various arbitrage relationships between the stock and the options market. You can essentially “lend” and “borrow” shares through the options market (*transaction costs may be high). If you simply look at short interest, you will not see the opportunities available in lending out your shares.
One common theory among bagholders is that short interest is a bullish signal, as a high short interest should be correlated with short squeezes. In my opinion, the bagholders should pay more attention to the borrow costs than the short interest. Firstly, if the bagholder is dealing with very small amounts of money (people who talk about short interest generally deal with small amounts of money), there is the free money aspect to lending our shares.
Secondly, short sellers often know what they’re doing. Short sellers tend to be professional investors who do it full-time as their job. Or, they may have inside information (e.g. the tech guy sending out emails knows that the stock is a pump and dump). The stock market generally does an excellent job in spotting pump and dump scams, so it’s difficult to make money shorting the obvious pump and dumps. Very high borrowing costs make market inefficiencies difficult to exploit.
However, there have been rare times in the markets where short sellers got burned en masse. 2013 was such a year, where going long high short interest stocks was a strategy with high returns. There was also a point in time where most fraudulent Chinese stocks were taken private. And then there was the Dot-Com Bubble and the junior mining commodities bubble (e.g. where guys like Eric Sprott and Salida Capital “made” a lot of money on janky juniors). So, sometimes the short sellers will give money to the longs. There have also been cases Sturm Ruger, which had an insanely expensive borrow for some reason (probably because a bunch of hedge funds looked out from their Liberal ivory towers and ‘spotted’ a gun bubble). In hindsight, Sturm Ruger was not a great short and has since recovered. Short sellers aren’t always right in the end… though they generally are.