Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Have Short Sellers Flagged Your Stocks?

Short sellers often identify red flags well before the Wall Street analysts or financial media spot them.

And if you are long in a stock that is heavily shorted, you'll need to dig deeper to find out why. You'd hate to find out that you were the last one to know that a key stock holding might be headed for trouble.

Twice a month, the Nasdaq and the New York stock exchange issue updated information about stocks that are heavily shorted. You can find that data on their websites, www.shortsqueeze.com or in the Market Data section of the Wall Street Journal.

Here's a key breakdown of the short interest lists every long investor should know about:

Biggest Short Positions
Stocks on this list are not necessarily there because they are in trouble. Instead, they may simply be seen as a negative bet on the broader stock market or a particular sector. In the most recent data, three of the five most heavily shorted investments are index plays such as the S&P 500 ETF (NYSE: SPY).

But you should glance at the list to see if any companies stand out. For example, casino operator MGM Resorts (NYSE: MGM) is the eighth most heavily shorted stock on the NYSE, even though the company's $4.5 billion market value puts it squarely in mid-cap status.

Largest Positive Changes
Like the list of biggest short positions, this list also tends to highlight big market and sector bets and therefore is usually dominated by large caps.

But watch for large changes and examine their implications. For example, it's worth examining why investors increased their short position in Mexican cement maker Cemex (NYSE: CX) by +30% at the end of August, even as its shares are closer to the 52-week low. Cemex is a proxy for construction in Mexico and the broader Mexican economy. So if you had any investments in Mexican stocks or funds, this spike in short interest could be flashing a warning sign.

Largest Percent Increases
By examining the largest percentage increases in short interest, you can look for short ideas that may have slipped under the radar.

For example, did you know that investors became doubly bearish on shares of Honda Motor (NYSE: HMC) in late August? The amount of shares held short grew by +111% in just two weeks. The move coincided with an ever-strengthening Japanese Yen, which would crimp profits for all Japanese exporters. The bet against Honda could be a good reason to bet against other Japanese exporters like Sony (NYSE: SNE), Toyota (NYSE: TM), Canon (NYSE: CAJ) and Hitachi (NYSE: HIT).

Shorts as a Percentage of the Float
To bet against a stock, short sellers must borrow shares that are being held in long positions in brokerage accounts (unless it's a "naked short" which is a topic for another day). Shares held by insiders aren't accessible, so these short sellers can only get their hands on freely-trading shares, or floating shares.

By looking at shorts as a percentage of floats, you see how much of the freely-floating stock is being held by short sellers. If the percentage is high, then short sellers could be on to something.

Recently, short sellers have been betting that grocery chain Great Atlantic & Pacific (NYSE: GAP), which is known as "A&P," might eventually go bankrupt. By the end of August, short sellers held negative bets on more than two-thirds of the company's float. The company had the last laugh here, announcing a likely sale of its Food Emporium chain in early September (after the latest short data were released), and reducing the chances of bankruptcy. Short-covering in recent sessions has pushed share prices up more than +20% this month.

Days to Cover
To calculate days to cover, divide the amount of shares held by short sellers by the average daily trading volume. As a hedge against a wrong bet, short sellers like to know how a round of short-covering would impact the stock. For example, as of August 31, 2010, short sellers held 17.44 million shares of Ritchie Bros. Auctioneers (NYSE: RBA). The company's average daily volume is 520,045 shares. If the short sellers are wrong about Ritchie Bros.' future, it will take around 59 days for these investors to make good on their bearish bets (based on the current average trading volume). The worst part (for bears)? As the short sellers bought shares to cover their positions, they would most likely drive the price higher and higher.

Looking at short selling data is extremely important, even if you don't go short yourself. If you're an active trader, you should get in the habit of reviewing the names in these categories at the beginning and middle of every month.