If you’ve followed the recent, high-profile attempts by retail investors to squeeze the short sellers of stocks such as GameStop (GME) and AMC (AMC) , chances are you’ve come across the research of S3 Partners.
Started 17 years ago, S3 calculates its own daily short interest numbers for over 50,000 global securities using huge amounts of data it gets from prime brokers, swap counter-parties, stock exchanges and broker feeds, and then normalizing them. That compares to the roughly three-week old data that gets released by regulators, with S3’s research finding that their numbers are within 10% of the actual numbers 90% of the time.
In recent years, S3 has created a host of analytics and other statistics around short sales, including a Short Crowding score, which measures shorting and covering events relative to market float to predict financing spikes, and the Squeeze Score, which ranks the risk that a company will get caught in a short squeeze, that it sells to both institutional and individual investors. S3’s head of research, Ihor Dusaniwsky, has become a frequent presence in the media recently trying to make sense of the volatile stock movements of the Reddit-driven securities and supplying the latest short-selling statistics.
We spoke to Dusaniwsky recently about the current short-selling environment, what short-selling statistics both long and short investors should be looking at and why, why it’s not really possible for a stock to have more than 100% short interest as a percentage of float and what changes he foresees in short-selling rules as a result of the meme-stock frenzy. Here is a lightly-edited transcript of our discussion.
What do you think has been going on with the latest surge in the heavily-shorted meme-stocks like GameStop and AMC?
I think we will continue to see these volatile price movements in certain stocks with higher-than-average short interest and high option holdings. Three of the main reasons behind these price moves are: a large retail presence and buying in these stocks; high options holdings which can produce delta hedging gamma squeezes; and short positions which can be squeezed and add to the upward buy side pressure on a stock. This action cannot happen in the larger cap stocks like Amazon or Apple, but can happen in smaller cap stocks that meet these criteria.
As far as short-selling statistics go, you focus on the absolute amount of short interest, rather than short interest as a percentage of float, as many others do. Why?
The number one fallacy of short selling is that short interest as a percentage of float is more meaningful than overall short interest. It’s like at a poker table if a guy bets seven $10 chips versus another guy who bets one $100 chip -- who’s ultimately betting more? In the same way, Tesla is much more important to the market than some micro cap with a small float, so you have to ask if you’re comparing the right things.
Short interest as a percentage of float works for telling you some things, such as liquidity and whether a trade is getting crowded, and the availability of stock loans. But every short sale also creates a “synthetic long” (more on this later) that increases the amount of tradable shares in the market. So not including these shares in the denominator of the short interest as a percentage of float calculation overestimates the percentage of shorted shares versus “actively tradable” shares in the market. This gives the impression that there is scarcity or crowdedness in that particular stock, when in actuality there is none.
But doesn’t a high short interest as percentage of float tell you how likely there is to be a short squeeze?
That’s the second-biggest fallacy about short selling. If you’re on a subway train and it’s crowded, are you getting off the train? It might be uncomfortable, but no, you’re staying on to get to your stop. But if at some point, someone gets on with a sardine sandwich, or they announce there are going to be extra stops or a twenty-minute delay, then you’ll get off. So, just because something is crowded (Mardi Gras in New Orleans, for example), it doesn’t mean there will be a rush for the exits and a short squeeze will occur.
So the final piece of the puzzle to a short squeeze are mark-to-market profits and losses. A squeeze only happens if a short seller suffers large mark-to-market losses; no one exits a winning trade no matter how crowded it is.
High short interest as a percentage of float is one of the things that can help precipitate a short squeeze, but the bottom line is, am I making money? Short interest as a percentage of float has a small effect on whether there can be a short squeeze or not. But, in actuality, a stock does not have to be crowded to be squeezed.
So next you have a crowded score -- are there high stock borrow rates and low liquidity in trading, for example? And the next step is to ask, is it squeezable? Not every stock that’s crowded is squeezable -- e.g. Apple. So although you don’t need to be crowded to be squeezed, if you are, the chances for a short squeeze are higher.
OK, so what are some of the stocks now with the highest short interest and do you think there’s a potential for any of them to have a GameStop-like situation?
Here’s a recent chart of domestic stocks with the largest amount of short interest:
The overall size and trading liquidity of these most shorted stocks as well as the size of the stock lending pool make these very unlikely candidates for a GME-type situation. It’s hard to move the market when there are multiples of retail trading volume overshadowing any impact even a well-coordinated effort would have.
For comparison, can you also show us which stocks have the highest short interest as a percentage of float?
Here’s a recent chart of U.S. stocks with the highest short interest as a percentage of float with overall short interest over $100 million, which gives us names that are more relevant to the broader market:
What are red flags investors should look for in companies being shorted that they really should stay away? And what are some buy signals when you’re looking at stocks being shorted?
For the long investor, looking at the short selling trends are very important. It should be a big red flag if short sellers are building positions in a stock you are long or are looking to buy in the future. If you see shares shorted growing, you need to ask yourself if the short sellers are seeing something negative in the stock that you aren’t?
On the other hand, if you are seeing shares shorted declining in size, then there are a lot of buy-to-covers hitting the tape and helping move the stock’s price up alongside long buyers -- this is a good sign if you are looking to start buying a stock or looking to build your position.
If you are a short seller, you can use shares shorted as an indication as to whether you are getting to the party on time or when everyone is leaving. If shares shorted is growing it can be a signal that you are in the middle of a momentum-based short trend that you can ride along with the rest of your fellow short sellers. But if you are seeing shares shorted decreasing, you may be swimming against the tide and be left holding the bag as most other shorts have left a trade that has run its course.
You recently introduced a new analytic called The Squeeze Score to gauge how likely a stock is to get caught in a short squeeze. How does it work and how should investors use it?
This is an analytic we will be introducing to our clients soon. We apply a multi-factor model which ranks short positions that are crowded and identifies likely short squeezes. We factor in size of short, S3 SI % Float Stock loan liquidity (which takes into account the creation of synthetic longs), trading liquidity and mark-to-market profit and losses to score the probability of a short squeeze in a stock. By utilizing our Short Crowding and Short Squeeze scores, one can manage unseen and explosive idiosyncratic risk and opportunity in an individual name, sector or for an entire portfolio.
What are some of the stocks with the highest Squeeze Scores currently?
There’s been a lot of criticism of the fact that short interest can go above 100%, or more than the entire float of a stock in extreme circumstances like GameStop. But you said in a recent tweet that that’s not actually possible. Can you explain?
Just like you can’t get five quarts of milk out of a gallon jug you can’t get true short interest as a percentage of float over 100%.
Using Float as the proxy for shares that are available to be traded on a daily basis misses out on one very important factor in calculating tradable shares. The general definition of float is a company’s outstanding shares less any stock restricted from trading such as insider holdings, IPO lock-ups and other beneficial owners. What is missing are the “synthetic longs” that are created as a result of a short sale which, in some stocks, can be a very significant number and should be added to the denominator. And they are in our S3 SI % Float numbers.
The ability of “synthetic longs” via margin and rehypothecation (or lending programs to increase the overall lending pool in a security) is why there is more liquidity for short sellers to access. As short selling increases, it in fact increases the ability to get stock locates as long share ownership expands and some of those shares are used in the stock loan market.
Before the short sale there was just one long shareholder of AAA stock, but after the short sale there are now two long shareholders of AAA stock and one short seller of AAA stock. All three investors have the right and ability to buy and sell their shares at any time so while AAA’s float has not changed, the amount of AAA tradable shares has increased. The short sale has created a “synthetic long” which does not affect AAA’s market capitalization or shareholder structure, but has increased the potential tradable quantity of shares in the market.
Do you think there will be any changes to the rules around short-selling as a result of what’s happened in the last month? Do you think there should be?
I would think that there will be some changes in the regulatory framework for short selling since it has been a hot topic of late. As Winston Churchill said, “Never let a good crisis go to waste”, and I don’t see politicians letting this opportunity escape their need to inject themselves in the workings of the financial sector.
I don’t think you can have all these hearings, and attention without politicians doing something, whether it’s just for optic’s sake or for the sake of good regulation. I’ve heard politicians and regulators talk about a return of the uptick rule, which I hope doesn’t happen, because it doesn’t really work.
More than anything else, I think there might be new disclosure rules, much like longs have to be disclosed. I don’t know if it will be like the European rules, which state that if your position is more than 50 basis points of the stock’s market cap, you have to be disclosed to the public. If I had to bet money, I think there will be more disclosure rules on the short side; people want to know who’s short. I don’t think it really matters -- what’s important is that the short position exists and not who’s holding it.
The problem is if you start to disclose shorts, do you discourage shorting? And it’s an important part of the market. In Europe, there are shorts that know exactly where the 50 basis point-mark is and always stay just under it.
What is the most important thing you hope retail investors learn about short-selling after the GameStop/AMC, etc. short squeezes?
For profitable short selling, like baking a souffle, timing and careful observation is necessary for a good result. Short sellers need to understand their profits are capped and losses are unlimited -- therefore you need to manage your short investments, maintain a strict loss limit protocol and not be emotional about your trade. Ride your profits, but if you hit your loss limits, buy-to-cover, figure out why your stock did not act as you expected, and move on to your next investment.
Real estate investors will tell you the most important factor in picking a property is location, location, location -- and one of the most important parts of short selling is timing, timing, timing. Know when to get into a short trade and know when to get out. Don’t be the last one into a short trade, the price move has already happened and if you see a lot of shorts exiting their trades, don’t ignore the trade flow, maybe you need to manage your position closely and get out of the trade, too. A GME short who got into their trade at $200/share, thinking there would be a quick pullback would have been down significantly as GME’s stock rocketed up to over $300/share. But a short who got in after GME started its ride down from over that $300/share level would have ended up with a profitable trade.
But short trading in stocks like GME and AMC is a risky business. The high short-term price volatility can inflict severe losses in a very short amount of time, sometimes multiples of the short seller’s initial investment, and if you don’t have enough collateral in your trading account, it can lead to margin calls and forced liquidation.
Short selling can be an important part of an investor’s trading strategy, giving them the ability to hedge their long exposure or generate Alpha in a downward trending market. But short selling can also be a drag on a portfolio’s returns if not executed and managed correctly. Small trades for a novice short seller in order to get familiar with short selling techniques may be a judicious way to start. And eventually, that investor will have another tool to use in creating a well-rounded and diversified portfolio.