Saturday, October 19, 2019 7:09:43 AM
When short-sellers are not interested in shorting the market because they fear a potentially ruinous rally – that is a sign of stock-market optimism.
The last time short interest in the SPDR S&P 500 ETF was this low was in early October 2018, just when everyone was preparing for lift-off and the Santa rally and what not, and short-sellers didn’t want to be caught on the wrong side of the trade. But instead, all heck broke loose.
It 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.
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