How to Defend Your Portfolio Against Short Sellers
Investing is a war. It’s a battle between buyers and sellers. Like real war, there’s a lot at stake in the investing game – livelihoods, educations, and retirements are on the line. And if any side has emerged as the definitive “bad guys” in the investing war, it’s the short sellers…
That brings me to a question that we recently received here at Trend Playbook:
How can I determine if short sellers are working against a stock I am looking to buy, and what can I do about it?
– Randy R.
Today, I’ll show you how to identify activity from short sellers – and how to avoid getting into a stock that’s about to get pounded lower by them.
On Monday, Greg told you about profiting from a short squeeze, a push higher that can be sparked by heavy short selling in a stock. A short squeeze happens when short sellers lose control of a stock (a good thing for buyers), but what happens when it’s the buyers who’ve lost control? That’s what I plan to help you with today…
The first part of Randy’s question was focused on spotting short sellers in a stock that he’s looking to buy. There are two solid metrics that can help you do that. The first is the short interest ratio.
The short interest ratio, also called the short ratio, basically calculates how many days it would take for short sellers to exit their positions based on a stock’s current volume. The idea is that if there are more shares short than can trade in a given day or week, shorts have to get desperate if they want to exit their positions quickly.
One of the easiest ways to find a stock’s short interest ratio is by going to Yahoo Finance, looking up a ticker you’re interested in, and then clicking the “Key Statistics” link in the left-hand column. You’ll find the short ratio on the right hand side of the page.
In my view, anything above 7 is a red flag. At that level, you’re starting to get to the point where short selling makes up a big position in this stock, and investors need to be focused on who’s in control. Anything below that level typically means that shorting is limited to investors who are hedging or using non-directional strategies like a pairs trade. You can ignore them.
The other metric to watch is the one that Greg talked about on Monday: the percentage of float short. This stat measures what percentage of a stock’s trading shares are currently bet against the company (unlike the short interest ratio, which focuses on shorting as a ratio of daily trading volume and how long it would take shorts to cover their bets). Again, if a large chunk of shares are bet short, there’s the potential that sellers are in control of the market.
For simplicity’s sake, you can find the percentage of a company’s stock that’s short in the same spot on Yahoo Finance…
What Can I Do About It?
So, if you’ve found a stock you want to buy that’s got substantial shorting, what can you do about it?
First and foremost, you need to think about why people are shorting the stock.
It’s easy to villainize short sellers, but I think it’s a mistake. Short sellers are really just like you – they’re motivated to make money by figuring out their opinion on a stock and then putting their cash on the line to back it up. No one ever shorted a stock because they thought it was a great, financially sound company. So if you’re looking at a stock with a lot of short interest, you need to ask why.
It’s one thing to think that short sellers are wrong, and it’s a whole other thing to merely write them off as the bad guys. Buyers who do the latter typically end up giving short sellers their money.
(For an interesting book that makes a good case for why shorting can be good, check out David Einhorn’s Fooling Some of the People All of the Time – it’s a stellar read from a great investor.)
If you think that short sellers are wrong, then the best thing you can do about a fundamentally strong position is wait. Ultimately, unless the company you’re investing in has enormous needs for cash (and has to tap the capital markets to stay afloat), its day-to-day stock price isn’t going to impact its ability to make money.
Shorts have the deck stacked against them – they have to pay to keep their positions open. If a company turns out quarter after quarter of good numbers, it’s not going to stay heavily shorted for long without incurring some major financial losses on those bets.
If you’re looking for stocks that are less disposed to short attacks, firms with low floats can be a good option. Because there are fewer shares trading, it costs short sellers a whole lot more to borrow shares to short, often making a bet against the stock uneconomical.
On the flip-side, low float stocks are also subject to bigger price swings…
Ultimately, if you’re concerned about short sellers, you should focus on fundamentally sound firms that can continue to perform at a high level long-term regardless of what’s going on in the market. And if you’re ever thinking about investing a firm whose management is actively battling short sellers, consider that a major red flag – if management is more focused on share price than fundamental performance, it’s rarely a good sign.
Combining strong fundamentals with solid technicals generally provides buying opportunities where the shorts don’t matter…
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