40 www.activetradermag.com • May 2010 • ACTIVE TRADER

Unlike long-onlyinvestors, shortsellers attempt toprofit from falling

prices. As a directionalapproach, short selling isstraightforward: sell stock andthen buy it back to exit, orcover, the position. However,short sellers must first borrowthe shares of stock they wish tosell.

Short sellers are often regard-ed as sophisticated market play-ers — traders who can identifystocks that are likely to under-perform their peers, and who actaggressively to exploit that outlook.Roughly 20 years of empirical evidencesupports this perception: Heavily shortedstocks lag the market, on average, earningprofits for short sellers.

However, these same heavily shortedstocks rise sharply in price more fre-quently than normal. Timing is also cru-cial, in light of the cost of borrowingstock to sell short.

Short sellers face unusual risks. Astock can theoretically increase 1,000percent or more as losses on a short posi-

tion multiply. The situation can becomedire if large numbers of short sellersattempt to exit at once, pushing up pricewith their buy orders. “Short selling andcrowded exits,” (Active Trader, October2009) explored this phenomenon, andshowed how European stocks in thesecircumstances rallied approximately 27percent, on average, within 60 days. Thefollowing describes how crowded exitsformed in several heavily shorted U.S.stocks as the broad market bounced backin 2009.

Don’t follow the crowd

A crowded exit occurs when short posi-tions in a stock are large relative to itsnormal trading volume and a catalystthen triggers an exceptional degree ofshort covering. Short sellers rush to covertheir positions, but elevated demand forstock creates an updraft.

At the start of 2009, market conditionswere perfect for short sellers — stockprices were falling and cyclical stockswith weak balance sheets were easy tar-

TRADING STRATEGIES

The hidden risks of short sellingThe crowds aren’t always wise when trading from the short side.

FIGURE 1: FORD — SHARES OUTSTANDING ON LOAN

Short sellers preyed on Ford in early 2009 but were caught off guard when the stockrebounded by April. Its percentage of outstanding shares on loan plunged as Fordpeeled away, a classic sign of a crowded exit.

Source: Data Explorers and Thomson Reuters

BY JAMES CLUNIE

ACTIVE TRADER • May 2010 • www.activetradermag.com 41

gets. As some firms bordered onbankruptcy, their stock pricesdescended toward zero.However, concerted governmentintervention in the global finan-cial system eventually led to astrong market rebound in March2009. As traders realized govern-ments would ultimately supportthe banking system, theirappetite for risk returned with avengeance.

Short sellers now faced entire-ly different market conditions.The stocks that appeared mostvulnerable in February 2009were now crowded with shortpositions, and some of the riski-est stocks were rallying sharply.Shorts needed to cover theirpositions, but liquidity was poorcompared to the increaseddemand for stock. This was clas-sic crowded-exit territory.

Crowded-exit examples

Researchers measure short-sell-ing activity by “short interest,”which is the closing number ofborrowed shares in a stock. Bycomparing short interest to vol-ume or the number of tradableshares outstanding (the “float”),you can identify stocks mostlikely to develop crowded exits.The stocks most susceptible tocrowded exits are economicallysensitive, possibly leveraged, and heavilyshorted relative to normal trading vol-ume.

Take Ford Motor (F) — a cyclical firmwith more than $100 billion of debt in

2009. Figure 1 compares a daily chart ofFord to the percentage of its shares out-standing on loan, a proxy for the propor-tion of shares that are shorted. In January2009 Ford had roughly 14 percent of itsshares outstanding on loan, an above-

average percentage indicating heightenedshort interest.

Figure 2 compares Ford’s price to itsdays-to-cover ratio (DCR), which is theshort interest divided by average daily

FIGURE 2: FORD — DAYS-TO-COVER RATIO

Ford’s days-to-cover ratio, a measure of short interest, peaked at 14 in March 2009before dropping sharply over the next two months.

Source: Data Explorers and Thomson Reuters

FIGURE 3: GANNETT — SHARES OUTSTANDING ON LOAN

Like Ford, Gannett had a high level of short interest in January 2009. Short sellersexited their positions as GCI rebounded, but they didn’t panic as they had with Ford.

Source: Data Explorers and Thomson Reuters

continued on p. 42

42 www.activetradermag.com • May 2010 • ACTIVE TRADER

volume. The DCR represents the numberof days of “normal” trading volume thatwould be required for all short positionsto be closed. The ratio rose to almost 14days by February 2009. Figures 1 and 2clearly indicate short sellers had crowdedpositions in Ford relative to liquidity.

By early April, Ford had risen 50 per-cent from its low, at which point shortsellers capitulated en masse, creating evenmore buying demand. By early May, Fordhad tripled in price from its March low.

Media firm Gannett (GCI) was anotherexample of pain for short sellers in 2009.

Like Ford, Gannett was anindebted firm facing tough busi-ness headwinds.

Figure 3 (p. 41) shows itsshort interest was exceptionallyhigh — the percentage of sharesoutstanding on loan hit 25 per-cent in February 2009. Figure 4shows its days-to-cover ratio waselevated (around 14 days) inJanuary 2009.

As GCI rose from roughly $2in March to $14 by December,its proportion of borrowedshares dropped by more thanhalf. But unlike the speed inwhich Ford’s short sellers fledtheir positions, Gannett’s shortsellers retreated gradually (com-pare Figure 3 to Figure 1). GCI’sshort sellers weren’t really caughtin a crowded exit; instead, theyslowly realized market condi-tions had changed.

Figure 5 shows the percentageof shares outstanding on loan forretailer JC Penney (JCP) in 2009.Short sellers began borrowingincreasingly more shares inFebruary 2009. However, shortpositions never got too crowded:JCP’s days-to-cover ratio variedbetween 2.5 and 5 in early 2009(Figure 6).

Nonetheless, as the stockrebounded, short positions col-

lapsed from almost 12 percent of out-standing shares on loan in February 2009to less than 4 percent by September, atwhich point JCP had doubled. Short sell-ers didn’t face a liquidity problem; theysimply miscalculated by building large

FIGURE 4: GANNETT — DAYS-TO-COVER RATIO

Gannett’s days-to-cover ratio fell from 14 in January 2009 to 4 in May 2009.

Source: Data Explorers and Thomson Reuters

FIGURE 5: JC PENNEY — SHARES OUTSTANDING ON LOAN

As the stock price doubled, short positions in JC Penney declined from roughly 12 percent in March 2009 to less than 4 percent within six months.

Source: Data Explorers and Thomson Reuters

Trading Strategies

ACTIVE TRADER • May 2010 • www.activetradermag.com 43

short positions in February andfailing to cover quickly enough.

Disappearing crowds

In September 2008 the Securityand Exchange Commissions(SEC) temporarily banned newshort positions in financialstocks, an emergency measuredesigned to prevent short sellers fromdriving down stocks.

Although the SEC’s ban arguably hurtshort sellers by limiting trade opportuni-ties, it also lowered the risk of crowdedexits; short sellers in mid-2009 facedfewer crowded exits in financial stocksthan if the SEC hadn’t acted.

Short sellers also retreated in othermarkets during 2009. As was the case inthe U.S., the most crowded short posi-tions on the London Stock Exchange werein cyclical and heavily leveraged stocks.Crowded exits abounded and some shortsellers suffered large losses in theseinstances.

Arguably, this washout contributed tolower market-wide short interest in early2010 compared to early 2009. Followingtheir recent losses, shorts generally lackcapital, and stock-lending data availablefrom the exchanges and research firmssuch as Data Explorers and SunGard, hasfound surprisingly few new short setups.

But just as crowded exits are rare andcapital is generally less available, shortsellers with good information can tradewith fewer liquidity problems. Ultimately,crowded-exit risk will return, but for now,conditions are ripe for selective, well-researched short selling.�

For information on the author see p. 8.

FIGURE 6: JC PENNEY — DAYS-TO-COVER RATIO

JC Penney’s short positions never got too crowded in early 2009, but its days-to-cover ratio fell as JCP bounced back in April 2009.

Source: Data Explorers and Thomson Reuters

Related reading

James Clunie article:

““Short selling and crowded exits””Active Trader, October 2009.How should short sellers handle situations in which the number of borrowedshares, or short interest, in a stock jumps?

Other articles:

““The short syndrome””Active Trader, August 2009.New research uncovers solid relationships between short interest and stockprices over the past 20 years.

““Bear raids””Active Trader, November 2008.Integrating Wyckoff analysis in a short-selling approach.

““The short view””Active Trader, April 2008.What does the level of short interest reveal about the market? Analyzing howthe NYSE Composite index behaved when short sellers flooded or fled the market since 1984 provides some insight.

““Short interest and relative strength””Futures & Options Trader, January 2008.Short sellers aren’t always right about a stock’s future direction. This techniqueidentifies opportunities to buy calls on stocks that are popular with the short-selling crowd.

““Short selling basics””Active Trader, December 2007.From a regulation standpoint, selling short is easier now than it was a yearago, but there are still things to consider before shorting a stock.

Article copyright 2011 by Active Trader Magazine. Reprinted from the May 2010 issue with permission from Active Trader Magazine. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data. 601730.2.0