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What's Really Affecting Short Interest?

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As always, I encourage people to look at the "why" behind the "what."

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In my conversations with bulls, they have been squawking about short interest: last month a record 18% of sales on the NYSE were short sales. This is bullish they say! All those shorts mean people are too negative and they will be forced to cover.

On the surface that may be what it looks like. But as always, I encourage people to look at the "why" behind the "what." There are two factors that are affecting short interest dramatically and both have to do with derivatives.

My fund is a very large short seller of stock and we represent a decent percentage of total short interest out there. But the reason we are short stock is because people sell calls. I have described these funds that buy stock and sell calls and deem it "income" for their investors. In reality, these funds can be very dangerous and risky if the market begins to decline. I can almost guarantee you that if the market drops enough, the risk will force these managers to sell stock to protect that "income."

So as these trades occur, funds buying stock and selling calls (which is a net bullish strategy), I take the other side on a ratio to create a volatility trade. I will never be forced to cover my short stock as it rises and in fact will short more. So instead of the comment "a rising market will force short sellers to cover" being accurate, in fact, as the market rises I will actually sell more shares short to hedge my exposure to the long call option.

Secondly, and perhaps more importantly from a sentiment point of view, the percentage of insider sales relative to buys has been growing dramatically. Insiders like principals in companies, are net sellers of stocks in a pretty big way. Part of this is due to normal diversification activity, but part may also be due to "them knowing something."

The way this actually occurs though is through a derivative transaction called a variable forward, which has some tax and profile advantages for insiders. Instead of actually selling stock, they enter into a contract with a broker-dealer to sell it forward with some risk (this profile allows some deferment of taxes). In hedging the transaction, the dealer enters the market and shorts stock.

So it is inside selling that is causing a great deal of short interest to grow.

Both of these factors account for most of the short interest you see being quoted out there. Both of these factors argue against large short interest being a bullish factor and actually argue for it being a bearish one.
No positions in stocks mentioned.

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