Hallie Elsner from Thomson Financial’s Corporate Advisory Services group discusses short selling.
Transcript:
Every two weeks, the major North American markets report short interest figures on publicly traded companies, but what exactly is short interest, how do investors sell short, and why does it matter? I’m Hallie Elsner and on today’s Corporate Advisory Insight, we’ll delve into the investment practice known as short selling.
First things first, what is short selling?
Traders who sell securities “short” are essentially borrowing shares from institutional investors or brokerage houses that currently hold positions in the particular security and subsequently sell them in the open market. At some point, the short seller must then cover the loaned shares by repurchasing and returning them to the lending institution. The short interest is the number of shares that have not yet been repurchased for return to lenders, which is the number that is published on a bi-weekly basis. Another important aspect to a short position in a security is known as the “short interest ratio,” which is the number of trading days of average volume that would be required to close out the short positions through share repurchases in the open market.
An interesting phenomenon ociated with shorting occurs when market participants target securities with high short interest ratios by rapidly accumulating the shares at ever-higher prices, forcing the shorters to cover their positions at significant losses. As the shorts scramble for shares to cover their loans, the incremental buying exacerbates the price move upwards and causes a “short squeeze”.
Now, why do investors sell short?
Short-sellers have many different motives for their activity and various objectives as to how they hope their particular short position will reward them with a positive investment return.
The most basic of short selling strategies occurs when traders sell borrowed shares of companies that they perceive as being over-valued in the marketplace, betting that they will then be able to repurchase those shares in the future at a lower price. In this case, traders are indicating a negative view on the valuation of the company in light of future prospects.
Traders may also short-sell shares as part of a long/short strategy with two or more companies involved in a merger/acquisition (deal arbitrage) or an equity carve-out situation (sum-of-the-parts arbitrage). In deal arbitrage, the strategy is to go long the target company and short the acquiring company, when the deal is a stock-for-stock transaction. In an equity carve-out situation, where a parent company owns typically 80% of one or more public traded subsidiaries,, the strategy is to go short the subsidiary company stock(s) and long the parent.
Now that we know how and why investors short; is this data significant and what does it mean to a company?
In general, analysts are split about the significance of this data. An overall increase in short interest is considered by some to be a bearish indicator, since more investors are betting on a downturn in stock prices. But many contrarian investors consider a significant increase in short interest for a particular stock to be a buy signal, since short sales eventually must be covered. One needs to study short interest over a long period of time and investigate periods of unusual activity to gauge the prevailing market sentiment.
I’m Hallie Elsner, thanks for watching.
Duration : 0:3:4
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