Get to Know the Holders' Hands, Part 2

Stocks with a large short interest relative to the float, like Taser (TASR - commentary - Cramer's Take), can behave erratically with little regard to anything more than the short-term technicals of trading. (If fundamental investing is akin to a chess game, trading Taser is more akin to a street brawl.)

Short-sellers also have costs that unleveraged longs don't face. When it is difficult to borrow shares (i.e., the borrow is tight), you might have to pay for the privilege of borrowing. As an example, when I was short Mony Group, I had a 2% annualized rate to pay on the last block of shares that I shorted. The rest came free, but that was before the trade got crowded. (When the borrow is not tight and if you are big enough, it is possible to get a credit, but that's another story.)

Another cost is paying any dividend that the company might pay. Granted, the stock is likely to drop by the amount of the dividend, but cash going out the door to support a trade makes a trade more difficult to hold on to.

10. Options Traders

Buyers of options fully control their trade and pay a premium for the privilege. Sellers of options give up some control of their trade and receive a premium for their trouble. Being short an option is like being short a stock; theoretically, the risk is unlimited. If the short options of an investor rise enough in value, either they or the margin desk will reduce their position. Long option investors face no such constraints, but they do face the continual decay of the time premium of their options.

When there are company-issued options outstanding, such as warrants, convertible preferreds and convertible bonds, another trading dynamic can develop. Because the company has offered the call options on its stock, unlike other investors, it can issue stock to satisfy calls. The dilution from share issuance can put a ceiling over the price of the stock near the strike price for the call options until enough demand exists for the stock that it overcomes the dilution.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.