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Why Short Interest Matters


Squeezeplay, anyone?


We could write a book on this one, but for now we will just cover the basics on short interest analysis.

Short interest data is reported on a monthly basis by the three exchanges (NYSE, Amex and NASDAQ.) These reports do not cover all existing short selling activity, but they are the only regularly reported sources of short selling information available.

Looking at one month's data is interesting, but almost valueless from a practical viewpoint. One month's data is a snapshot. A good analogy is an imagined snapshot of a baseball game with the players on the field and a ball is pictorially frozen in mid-air by the camera's fast shutter speed. In this picture you can't tell if the ball is being hit out of the park or if it is a throw towards home plate by an outfielder. Snapshots only have meaning if you look at many of the previous snapshots. Put all the available snapshots together and you get a much clearer picture of the game's action. The same is true of short interest data - a historical perspective is needed to glean meaning from the data.

For instance, what if you knew that in May 1999, WorldCom's short interest ratio was 1.91? By itself, that's not going to tell you a lot, but:

The above chart puts May of 1999 into perspective for WorldCom (at the Minyans in the Mountains 2 seminar we promised to publish this chart in Minyanville.) The short ratio had dipped to a lower low by such an extreme that our Erlanger Short Intensity rank hit a low of 0%, which means that short selling intensity was extremely light (100% is our extreme level of heavy short selling intensity.) The irony that we see all the time is that short sellers were plentiful in the 1990s when WorldCom was in a long-term uptrend, but were relatively scarce when it was in a long-term free fall this decade.

The human mind contains a widget that makes people fight uptrends (by short selling) and fight downtrends (by going long.)

Extremes of sentiment reflect capitulation of that "fight" and acceptance of the prevailing trend. Unfortunately it is at these extremes that the trend often reverses.

Short interest and sentiment analysis, however, are not just about measuring extremes. Life and the markets are rarely that simple. Gauging sentiment is a two factor process. Once a sentiment measure has been taken, one must determine how the market is moving relative to that sentiment. If there are many more bulls than bears, how are the bulls doing? It is unwise to think that because there are too many bulls, they must be wrong (however such an observation does increase the risk for bulls.) Prudence dictates waiting for the market to begin to move against those bulls. So the two factor model gauges both sentiment and price action. Both longs and shorts can be squeezed, it's just number crunching to determine whose turn it is in the vise.

A recent example is DAL - Delta Air Lines. Heavy short interest in the 1990s helped price lift off to its highs in 1999. The short interest ratio is currently about average at 9.02, but the story is in the Short Intensity Rank and the DMA (displace moving average) channel. DAL has been unable to get above its month's DMA channel since the late 1990s. Those moments in time during this period of weakness when the short intensity was lightest (see arrows) were also optimum times to sell short. The two factor model identified both extremes of sentiment (too few shorts) and poor relative price action - it has been the bulls caught in the vise this decade for DAL.

Our two factor model does not encompass all factors that influence a stock's price action. For DAL an inverse relationship to the price of oil clearly is an additional factor. The beauty of short interest data is that it is stock specific and relates to investor opinion. Few other data series offer that kind of insight.

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No positions in stocks mentioned.

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