turned into the worst October anyone could remember, and a near-20% sell-off of the S&P 500 Index by Christmas.
Short sellers borrow shares to sell them high, hoping for prices to drop so that they can buy them back later at a lower price, return them to their owners, and pocket the profit. They have to buy back those shares at market price in order to close the trade. When short interest is very high, this means that short-sellers who want to take profits after shares have plunged end up buying shares massively as shares are plunging, and they put a floor under the market.
But when there is little short interest, because short sellers are afraid that shares could surge and rip their faces off, that floor does not exist. And this is what happened last October. The market started dropping on little short-interest, and short-sellers weren’t around to buy back their shares to take profits.
Instead, short-sellers piled into the market to short the falling market as the month went on, and continued to do so through December before short-interest began to decline in early 2019.
Conversely, when short interest is low, as it is now, there isn’t going to be much support from short-sellers when shares do rise. Shorts would lose money on a rising market, and they have to buy shares to get out from under their trades, and this can trigger very sharp short-covering rallies. But with short-interest low, this isn’t going to happen on a large scale.
But it’s not that simple. Short-sellers are speculators that take big asymmetrical risks. There is another class of speculators, but they fear a sell-off and they’re deleveraging:
