Why Short Interest REALLY Matters

“Short Selling”

Like saying "Trump" to a Democrat or "Biden" to a Republican, the mention of the word brings up revulsion and disgust amongst retail investors. Short selling is the great scapegoat.

If a stock trades down against – especially big – many retail investors flock to this as the reason why!

In today's HX Daily, we are not going to talk about the moral (or immoral) nature of short-selling nor the role it plays in the broader stock market, but we ARE going to talk about the role it plays in the price action of "meme stocks."

We believe short selling is particularly misunderstood in this area, and understanding it can make you a better trader and investor.

First off – what is “short selling”?

Short selling is a way for an investor to benefit if the price of a stock goes down.

In a normal situation where you buy a stock, you make money when the price of the stock goes up.

Let's say a stock trades at $10 a share, and you buy ten shares. You now have invested $100. If the stock goes to $15, the value of those shares is now $150. You can sell those ten shares and book a $50 profit. Pretty easy to understand – right?

In the case of short selling, you SELL shares that you technically don’t own but have “borrowed” from someone who does own them.

Sounds weird, right?

Here is a good article going through the basics -

We will also give you our version.

Let's say you own those ten shares of stock. Someone comes up to you and says – "Hey, can I "borrow" these shares, and I will pay you a fee (1%)? No matter what, I will return the ten shares when you want them."

Not a bad deal. You owned the stock anyway. Who wouldn't want an extra +1%?

That investor who then "borrows" those shares goes out and sells them at $10. They put $100 of cash in their bank account.

If the stock goes down to $8, the short seller buys shares in the open market for $80 per share ($8 per share times 10) and gives you back your shares.

They just made $20! They took in cash of $100, owed you the shares, but then bought the shares for $80 and returned them to you. They no longer owe you the shares back and will book the difference.

Conversely, if the stock trades up to $12 and the short seller goes to close the trade, they have to pay $120 for the shares. This means they paid $20 more than the $100 cash they initially took in and now have a $20 loss.

It sounds complicated but is pretty simple and – at this point – automated by the brokerage system.

It is not as if individual investors are going out to each other and saying – "Hey, can I borrow your shares?"

Instead, when you buy shares with every major brokerage, the default option is for the brokerage to "lend" those shares to other investors. You can opt-out and tell them they can't do it, but it is a hassle, and almost no one does it.

This has created a robust two-way market where one can benefit from both the increases and decreases in share prices. That is an excellent option for investors (including you) to have!

What role does all of this play in the rocket ship advances of the “meme stocks”?

With any given stock, a set amount is usually available to borrow. For most stocks, it might be almost all the shares out there, but for other stocks, there may be reasons why some shares might not be available. For instance, there is a large private owner.

If there is much demand to short a stock (for instance, for troubled businesses like GameStop Corporation (NYSE: GME) and AMC Corporation (NYSE: AMC), then you might see more demand for shares than are available.

This drives the "cost to borrow" higher. Instead of paying the 1% we discussed, you might need to pay 2%, 5%, or even 25%!

That makes the short a lot less attractive. If you are paying 25% to borrow the stock, it needs to go down at least -25% before you make any money.

There are two ideas in the meme stock community about this system, though, that are fundamental misperceptions.

The first is that when these investors crowd into a stock, they believe that they may lead the "borrow" to get pulled. This means that the amount of stock available is reduced.

This isn’t necessarily true, but the opposite might happen.

If the stock is rallying big, there might be more natural sellers, increasing liquidity. This might result in MORE shares being available to borrow.

The real impact on the short sellers has nothing to do with the borrow but rather the price!

At its core, short selling is flawed versus long buying.

Buy a share of stock for $100, and it could go to $200, $300, or even $1000. If it goes to $0, though, you only lose $100.

Short a share of stock for $100, though, and you can only MAKE $100. Yet you could lose $200, $300, or even $1000.

This is what is called an "asymmetrical return ."In this case, the reward on one side is far less than the risk on the other.

What happens with these short squeezes has nothing to do with the "borrow" but rather with good old "risk management."

Experienced managers know that once they start, the stock is not bound by any valuation or fundamental rules. It literally could go anywhere.

They only realize losses if they "cover" (they buy back the shares at a high price to return the "borrowed" shares), but many of them don't (or can't) take on the short-term volatility.

This is the same as if many retail investors ganged up and decided to borrow and short a stock!

The price would go down, and some owners would sell out of either fear or because their process demands that they limit losses.

The “meme stock” squeezes are the SAME EXACT mechanism as the short seller attacks.

One final word, and that is on what is called "naked short selling."

This is when you sell shares you have not (or have not yet) properly borrowed. The idea is that shorts can come and pressure the stock even more and force sellers.

Is it a real thing?

The answer is "yes," but it happens only on a small scale. It is not legal, and the vast majority of the trading is dominated by heavily regulated financial institutions that would lose far more from the penalties for enabling it than they would gain by doing it.

The idea of naked short selling is behind the drop in a stock might satisfy the "tin foil hat" crowd, but it is not a thing in a material manner.

…and who cares?

We can see plenty of good old short squeezes and significant gains by just doing what investors have been doing for a hundred years – ganging up on the shorts. Just now, it can done on the internet and by one-thousand-fold!

What do you think of “short selling”? Evil? Beneficial? Share your thoughts in the comments section online or email us at [email protected].