Thursday, September 14, 2006

Lots of Interest in Short Interest

Most of us that have been through a few market cycles keep short interest on our radar. I don't have a level that tells me anything in particular, more of a rough gauge of how many folks have crowded into the bearish trade.

But in recent years I've seen a fair amount of commentary that indicates record high short interest- followed by even higher records- is not what it seems. That's because there are increasingly complicated program trades and derivative-type hedges that use shorts, puts, calls, and other sorts of exotica, in an effort to target a particular niche or strategy.

For example, over on Minyanville, John Succo provides one of the most clear explanations I've seen of how this can actually work.

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.

Change of subject: while you're there, check out Kevin Depew's Five Things You Need to Know. Mr. Depew somehow manages to distill each day's market buzz into a very funny and easy to read column. Seriously good stuff.


Anonymous Jeff said...

John Succo is correct in the observation that short interest does not really show sentiment, but there is a problem with his reasoning.

I also have a short position that is very large relative to the size of my fund, yet I am net long through options. I always have some of the same volatility trades he describes.

Here is the problem. He may or may not be right about the behavior of managers r who are long stock and short calls. My guess is that some of them will roll down the call positions rather than sell stock.

But he is ignoring his own behavior! As the stock declines, he buys in short stock since the calls are losing deltas (just as we do, and just as every professional options trader does).

On balance, short stock against options is closer to neutral than people think.

1:27 PM  
Blogger FRx said...

Thanks, Jeff.

I wonder what % of short interest, or even spikes in the put/call ratio, are simply explained by funds like these?

also, since shorting stocks, along with call and put options, has been available forever, I wonder why the big spike over the past few years?

11:08 PM  

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