As the stock market grows in consumer exposure, so too do the strategies and tactics of those who participate in its complexity. Over the past few years, I've seen a significant shift in the dynamics, driven primarily by a new breed of retail trader. Once seen as peripheral to the market's core, retail trading has surged into limelight, bringing along a suite of unique behaviors and techniques. Among these, one stands out – short selling.
Short selling, or betting on a stock's price to decline, was once a technique almost as exclusive as options trading and utilized by professional hedge fund managers and financial institutions. But where traditionally these entities utilized shorts as a tool for hedging against potential losses or managing risk, aggressive retail traders see as a quick way to capitalize on market direction. Sure, we all have had access to short selling and options for years, but its become more pervasive and commonplace even among the most inexperienced trader.
The explosion of easily accessible trading platforms and wealth of readily available financial information has made learning these trading concepts a simple(r) exercise. And while I don't believe there were limits on short selling, outside of having a margin account, most novice retail traders can short stocks easily.
There is, however, critical distinctions in how retail traders employ short selling compared to their professional counterparts. Retail traders tend to be more speculative, driven by short-term gains and a gambling spirit. They (We) are often triggered by online hype and sentiment rather than detailed analysis of a company’s financials or market conditions. This type of behavior leads to extreme volatility particularly in lower float, lower priced stocks.
Professional traders, on the other hand, are said to use short selling as part of a broader, more balanced strategy. They employ it as a hedge against market risk, reducing potential losses if their long positions decline in value. They also perform more research and have more process in place to protect themselves when initiating a short position. While they are certainly prone to error and mistakes, they have a documented approach provided by their risk desk that they are instructed to follow.
Retail traders, on the other hand who dabble in short selling tend to misunderstand its inherent risks. They often underestimate the potential for significant losses. Additionally, with the growing interest in shorting stocks, the volatility across the market is likely to grow.
Here is quick summary of the percentage of short interest held by retail traders in US market:
- 2010: 5%
- 2015: 10%
- 2019: 20%
- 2021: 25%
- 2023: 30% (projected)
These increasing numbers are most likely due to pure accessibility of tweets, posts, and blogs on "how to short a stock". The biggest misunderstanding of short selling is primarily failed risk management. While it is not untrue there are serious and rapid gains from shorting, its certainly something to fully understand. The influence of fear and greed, those motivators for human behavior, cannot be underestimated. Many retail traders get swayed by the fear of missing out (FOMO) on potential profits and the greed for quick returns. This emotional response can blind us.
As an outcome of this increased short accessibility, I think we are seeing more frequent squeezes on stocks with smaller market caps. This helps stocks get out of their trading ranges more often and has been providing solid returns on small cap spikes. I could be imagining this, but the action feels different.
Here is an example just today on Galmed Pharmaceuticals (GLMD). With a float of 1 millions shares it spiked 100% in just over 30 minutes. The short volume? Well, over the past 5 days 55% was short.
The explosive action resulted in 3 halts to temper the volatility and most certainly hit numerous short stops along the way. That's the risk of trading, but there are ways to increase your success rate. So if you came here wanting to find a how to evaluate a short here are a few tips you can include in your shorting process.
- Scan for Stocks: Look for stocks that have surged by at least 30% during the day. If a stock shows up on this radar, it's important to conduct due diligence to determine if it fits the criteria for a good short.
- Understand the Catalyst: Check news for the reason behind the stock's rally. The stock's rapid increase might be due to overhyped news or events that could lead to a short-lived rally and a rapid price reversion. (ex. XYZ company has secured LOI for $20m contract for undisclosed company. Here, a letter of intent is not a signed contract and "undisclosed company" suggests the business doesn't really want public exposure. I believe Nikola had a few like this in past).
- Evaluate the Float: Avoid stocks with very small floats (the number of shares available for public trading) or extremely large ones. Stocks with a float of less than a million or more than 30 million shares are risky for shorting. The sweet spot is stocks with a float between 5 million and 20 million shares.
- Check Market Cap: Avoid shorting stocks with a market capitalization above $250 million, which could signify high institutional ownership.
- Institutional Ownership: Steer clear of stocks that have over 40% institutional ownership, as these institutions have substantial funds and could stabilize the stock price (meaning they will buy the dips as they see it as a conviction and longer term hold).
- Stock Price: Both very low-priced stocks (below $2 per share) and high-priced stocks (above $20 per share) are less favorable for shorting due to the potential volatility or more robust fundamentals and institutional ownership respectively.
- Check Short Interest Rate and Borrow Fee Rate: These rates indicate how many traders are trying to short a stock and the cost of borrowing shares for short selling. If the cost is above 60-80% for small-cap stocks with low floats, it could lead to a short squeeze.
- Assess Potential Dilution: Companies with less than three months of cash available are good candidates for shorting because they will likely need to raise cash soon, possibly through a stock offering, resulting in share dilution. (*** This is a huge signal.)
- Analyze Historical Chart: Look at the one-year historical chart to find potential 'bag holders' - investors who bought at a high price and couldn't sell in time. They often wait for a price retrace to offload their shares.
Finally, it's crucial to remember that even with all these indicators, shorting stocks in hot sectors or those influenced by external factors (like social media hype) can still be risky. For a "safe" short, the stock needs to meet all the indicators without being a part of any recent trends or hype.
One of the truest sayings of the market is when it's time to short, you won't want to.
Lastly, tops of moves are hard to short because they very often will do things to trap in bears and then make a false breakout. Once head-faked they reverse too quickly for people spiked out to re-position. This is something to plan for with initial market drops. False starts before spikes are common.
Technically, there is nothing different about a short or long position on a chart. As the charts are reflecting the truest price and value at a given time. Now whether shorts are getting more anxious due to extended sideways positions - that is arguably true as the borrowing rate can help nudge into closing positions. This is where the squeeze begins to take place. (If using MOMO Pro+ MOMO Squeeze and Short Interest combined can help uncover these targets. Also MOMO Pro helps with the scans and news mentioned above. MOMO Pro was built to both long and short traders equally so regardless of bias it should be transparent in using MOMO Pro).
To wrap it up... The market is increasingly seeing retail traders using short positions and as retail traders delve more and more into smaller caps using shorts, we will see more explosive breakouts. For those inclined, there are a few steps listed above you can take to be better disciplined in short trading. And, if trying to hunt out short squeeze targets, MOMO Pro+ can help.
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