Written By: Marin Katusa Short selling is a touchy subject.And I can see the industry hate mail coming already.Katusa is heading to the dark side of the industry and joining the short and distort syndicates.
The exchange should really bring in the same level of regulation for the short and distort crowd as they have for the longs and loud crowd.If you’re going to short a stock, you better make sure your research and analysis are correct.If it’s not, you will lose more than your shirt. You’ll lose your wife’s closet of wardrobe if you’re not careful—and that’s when the real pain begins.The basics of going long and selling short are as follows…A long position means you own a stock, so you make money when the stock rises.On the other hand, a short position makes money when the share price of the stock falls.
We have all heard the analogy, “buy low, sell high”.Short selling works in the reverse manner, i.e., sell high first, then you buy back low.To sell short, first you borrow the shares from a broker.The shorter pays a fee per share for the loan along with any dividend payments to the holder of record.A lot of people don’t know that their brokers are loaning out the shares of their clients without the client knowing. And the brokerage firm keeps the profits (interest) off the borrow for themselves.There is a whole article on this topic that reveals the games brokers and brokerage firms play with their clients' stocks.But I’ll leave that for another day.Now to do some short selling, you must put up a percentage of capital – this is called the margin requirement.If the position moves against you (stock price rises) you may be required to add to your margin. The most you can earn on a short sale is 100%, whereas the maximum loss could be infinite.The professionals who short take massive leverage. So the gains are multiple times what to the actual margin posted. Note: If the exchange forced the short seller to have the same margin requirements as the longs, that alone would take away a big incentive of the shorters. But we now live in a world with different rules for different people playing the same game.The short position is “covered” by buying back the stock you borrowed on loan.The profit or loss is the difference between the price you sell the stock at and the price at which you buy it back.In a capital-intensive sector like natural resources, booms and busts lead to both long and short speculations.
I’ve had my share of battles taking on shorts in the mining sector.In the table below, you’ll see a list of the most heavily shorted North American listed mining and metals stocks.What this table tells you is this…In the case of a company like McEwen Mining [ ( MUX:CA[TSX] - $1.45 0.04 (2.68%) ), ( MUX[NYE] - $1.09 Trade )], short sellers are borrowing about 14% of all shares outstanding or 17% of the equity float as shown in the chart.That’s 54 million shares lent out by brokers, who collect fees and interest for the borrow.Aren’t they just spring peaches!?
While short interest is a key puzzle piece, a serious investor should take it a step further and look at the “Days to Cover” ratio.The days to cover represents the hypothetical number of trading days required for the short position to be covered. The higher the number, the longer it will take to close the position. For the math nerds, the equation is total shares short divided by average daily trading volume.Now you need to take this number with a grain of salt.The reason is that this ratio assumes the short position is the only buyer of the stock. This is a highly unlikely circumstance.And it means, therefore, that the days to cover ratio understates the amount of time it takes to cover a position.Below is a chart which shows the Days to Cover ratio for the most shorted mining stocks.
The energy sector also battles a lot of short selling.And I’ve published bear case scenarios equivalent to a “short report” in order to establish a very conservative view on different energy sectors.One of the first pieces of analysis we perform is to see which stocks are the most shorted.Below is a list of the most heavily shorted energy stocks in Canada. Compared to the U.S. markets, it’s a small list of companies that have a significant short position.And here is the days to cover ratio of Canada’s most shorted energy stocks.As I mentioned in the introduction, the U.S. markets are far more active in short selling.Below is a chart which shows the most heavily shorted stocks in the U.S. Energy sector.You’ll notice I had to stop the chart at 20% short interest for the U.S. energy sector.In total, there are over 120 companies in the U.S. that have a short position equal to 5% or more of the equity float.Compare that to Canada’s 12 companies with a short position of at least 5%.Now let’s take a look at the Days to Cover for U.S. Energy’s most shorted stocks…
A short squeeze is when pressure is put on the short seller, in an attempt to force the shorter to cover the position.Covering the position means buying back shares, which pushes the stock price higher. This is where the days to cover information becomes so valuable.The less liquid the stock, the harder it is for the shorter to buy back shares in the market without taking the share price a lot higher.I was just a bystander in this one, but the cannabis company Tilray had a major short squeeze last summer. Share prices catapulted from $100 to $300 per share in the span of a few days...Many shorters were blown up in the process as margin calls forced them to cover the position at any price.Since the squeeze, Tilray has dripped lower, and is now trading well under its $30 IPO price.Those who did not get crippled on the squeeze appear to have won this battle.
Now I’m really fired up.Next week I’m going to publish part 2 of this short selling series where I’ll get into a few things: