Today’s Thought of the Day is a post on Short Interest by John Succo at Minyanville.

Professor Succo asks and answers the question: Is the rise in short interest really a bullish occurrence? To answer that question one must understand why short interest has been rising. So… What’s Really Affecting Short Interest?

John Succo:

In my conversations with bulls, they have been squawking about short interest: last month a record 18% of sales on the NYSE were short sales. This is bullish they say! All those shorts mean people are too negative and they will be forced to cover.

On the surface that may be what it looks like. But as always, I encourage people to look at the “why” behind the “what.” There are two factors that are affecting short interest dramatically and both have to do with derivatives.

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.

Secondly, and perhaps more importantly from a sentiment point of view, the percentage of insider sales relative to buys has been growing dramatically. Insiders like principals in companies, are net sellers of stocks in a pretty big way. Part of this is due to normal diversification activity, but part may also be due to “them knowing something.”

The way this actually occurs though is through a derivative transaction called a variable forward, which has some tax and profile advantages for insiders. Instead of actually selling stock, they enter into a contract with a broker-dealer to sell it forward with some risk (this profile allows some deferment of taxes). In hedging the transaction, the dealer enters the market and shorts stock.

So it is inside selling that is causing a great deal of short interest to grow.

Both of these factors account for most of the short interest you see being quoted out there. Both of these factors argue against large short interest being a bullish factor and actually argue for it being a bearish one.

John Succo / Minyanville


One of the favorite targets of these “income funds” selling volatility has been bank stocks. The option open interest on BAC alone is staggering (and many of the big financial stocks and indices look similar). You can check it out yourself on CBOE.

Funds have been selling puts and calls at ever decreasing volatilities (and premiums) to make “income” for their funds. This is a risky strategy, since with decreased volatilities ever increasing amounts of leverage are needed to make the same percentage returns.

Given the massive numbers of options floating around, an unwinding of those trades will be disastrous if technical support levels are broken. For now, hedge funds using this technique have been getting away with playing with fire for so long they no longer see any risk. Every month more options are added to the heap. Just like little kids playing with sticks and matches, that pile of tinder will ignite at the wrong time with the wind blowing from the wrong direction. It is only a matter of time before we see some serious burns.

Mike Shedlock / Mish/