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If We All Thought the Same Thing, There Would Be No Market


A few thoughts...


The NYSE tacks on only 100 million new short shares this month and the NASDAQ tacks on about 90 million new, both decelerating advances compared to last month. Both are new records for the exchanges, a regular occurrence these days.

NYSE short interest for the period between mid-July and mid-August gained 1.01%. The value of the NYSE composite index added 2.54% during the same period.

NASDAQ short interest rose 1.18%. The NASDAQ Composite was up 5.41% during the same period.

The graph I've been using appears below. It uses January 2003 as an index year (for no other reason than that was a complete year bull market and the first year in which I collected data. I'm not certain the graph is anything more than informational, but I think it is worth pointing out the pattern of the indexed NADSAQ Comp (in dark blue) after each time it was eclipsed by the indexed value of the NASDAQ short interest (light blue).

The broad separation between short interest on the NADSAQ and the value of the NASDAQ comp appears to be a potential indicator of future market gains over the last 3+ years.

Thanks to Jason Goepfert for providing a graph showing that 2006 short interest gains have outpaced call selling, one alternate theory for why short interest has been rising so rapidly (more on this later).

The 168 biotech stocks on the NASDAQ Biotech Index (NBI) as of the short interest cut-off date saw their overall and average short interest increase by 1.49%. The NBI gained 4.14% during the same period. Short interest of the NBI as a percentage of overall NASDAQ short interest gained slightly to 11.62%.

Short interest in the IBB, the iShare ETF for the NBI, rose 10.68% the first gain in the last six months. The BBH, a HOLDr ETF approximating the AMEX Biotech Index (BTK), saw short interest decrease 7.47%, the fourth decline in a row.

It is sometimes argued in these pages that paying attention to short interest is futile. I'm guessing the theory is that all these positions are hedged. With the rise in zero-volatility funds, there might be some truth to this point of view.

John Succo pointed out on the Buzz that short interest is related to the all-time high levels of call selling. He noted that he'll take the other side of these trades (buy the calls) and then short against that position. He noted he can keep shorting until he's 1:1 with the calls and "never have to cover a share." I'm not dumb enough to doubt John about options, but this struck me as odd since in my corner of the world (dev-stage biotech), few (if any) of these companies have enough outstanding call contracts to cover their existing short positions.

So I pulled up Microsoft (MSFT), figuring that sloth-like stock would attract call sellers like light attracts moths. I was right. There are about 360 million share equivalent call options open and only 74 million shares short. This is exactly the situation John suggested.

I wish I had the time to dredge through a bunch of other stocks to see whether what I observe on a regular basis (short interest much higher than open call volumes) or what's currently present in MSFT (open call interest much higher than short interest) is more common. The graph provided by Jason Goepfert in Kevin Depew's "Five Things" column today provides part of the answer, and that appears to suggest the MSFT situation is less common.

If the overall short interest tells us nothing, as John suggests, then the difference between the number of outstanding call options and total exchange short interest might because that ought to be closer to an "unhedged" short interest number that could truly indicate bearish sentiment.

I have a couple of thoughts about John's excellent argument:

  • Call selling is itself bearish. Both he and I have written about zero-volatility hedge funds and the fact that their call selling is not identifiably bullish or bearish. It's simply considered income. That said, I've spoken to enough traders who generate their income in this fashion to know fundamental analysis often plays into their trading strategy. They are more likely to aggressively sell calls when they think fundamentals are weak. So even if short interest is 100% linked to call selling as John implies, doesn't it remain at least a plausible surrogate for bearish sentiment? Sure, it's not a direct indicator. And granted, a good portion of call selling might not be related at all to fundamentals. I know some of it is, though. So even under John's scenario, increases in short interest are still something of a mirror image of the bearish sentiment of call sellers.

  • Short sales have costs. Even in John's scenario, a rising market costs short sellers. If someone runs a short position equivalent to his calls, this is not a winning trade. He or she eats the cost of purchasing the calls and eats the costs associated with borrowing the shares. I'm certain John was referring to a 1:1 ratio only for dramatic effect for this reason, but I agree with him, the concept makes for a good illustration. However unrealistic an example of a 1:1 ratio is, it's a useful illustration that shorting has costs that increase when the stock climbs, even when you're hedged with calls.

  • Do calls protect against the rare short squeeze? I hesitate to even bring up short squeezes because they are really quite rare. In the rare situation where your borrow gets called, however, do the calls really help hedge the short position? Perhaps if you can do an early exercise on the options, but I understand that's pretty rare.

Short positions and their hedges carry an expense. Dividend payouts, borrowing premiums, margin rates, and derivative costs all make a dent in the P&L. I still maintain this short bubble will matter at some point. I've admitted the rise in short interest will not cause a rally, only accelerate one already underway.

Short interest is like most of the macro concepts discussed around here in the 'Ville (high debt, low savings, Fed liquidity, inflation, deflation, stagflation, etc.) and are very worthwhile to keep in the back of your mind as a factor in your risk analysis.

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