Tuesday, July 26, 2011

Short Selling Method

Short Selling is sell with the expectation of price dropping and the intent of buying the stock back to replace at a cheaper price.  There are substantial risks with short selling, some of which can be avoided through education on the process.  Short interest is a measure of the total share volume that is currently short the stock.  When a person short sells, the order must be identified as a short sale and these statistics are kept for each stock by the exchange.  Short interest can be a source of demand if buyers become enthusiastic for the stock and price rises prompting some short sellers to reduce risk by buying back stock to replace and closing the short position.

A short interest ratio is found in several newspapers and databanks and is a calculation of the latest reported short interest positions for the month divided by the daily average trading volume.  A high ratio is considered bullish while a low ratio is considered bearish.  A ratio of 2 is considered 2 days potential buying power.

The short interest ratio is called a contrary opinion indicator because an increase in short selling is an indication of a strong potential demand element as short sellers are likely to close positions quickly if the market price proves them wrong.  Clearly it is necessary to have a fundamentally based informed opinion on the potential for price reversals during periods of high short selling to see this as a valid approach.

Odd lot short sales has been considered a measure of uninformed investors and was used by investors to give evidence of market bottoms as late comers to the market were considered uninformed.  This is less valid for the current market.

Specialists short sales are also available as a data source for measuring short selling.  This is considered the smart money.  Often investors watch the ratio of specialists short sales to total number of short sales to give an indication if the smart money is bullish or bearish.  This can be distorted by the increased use of derivatives in the recent times.  A short sell can be used as part of a bullish strategy as so can skew the basis for interpreting the ratio.

Our critical day research can be used with stocks that are highly correlated to the major indices.  When a critical day is an expectation of a change in direction of the price trend, short sellers have advance warning either to prepare an entry strategy or an exit strategy for a position already opened.