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Market Correction Makes One Group Happy: Short Sellers

Market volatility brought on during the correction off the April highs has eaten into many investor portfolios—but also generated opportunity for short sellers.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
A trader at the New York Stock Exchange.

During the market's massive rally from the March 2009 lows, going short was a mostly losing proposition.

But with the major averages in correction mode since April 23, the shorts got busy again in May and are likely to stick around until the market shows signs of calming again. Short interest rose more than 1 percent for the month.

"The recent market collapse has once again rewarded the short sellers," says Dylan Wetherill, president of ShortSqueeze.com, a website that monitors daily short movements. "Short selling is back and they have been targeting Nasdaq stocks for over two and a half months now."

Short-sellers borrow shares of a stock, sell them to a third party, and then buy them back at a later date in hopes that the price will fall and they can pocket the difference.

An 80 percent market gain doesn't provide much atmosphere for short-selling—but a 13 percent drop certainly does.

"I was excited to see the shortages tick up a bit. That gives us a catalyst for a bid to cover at some point," says Justin Wiggs, vice president of trading at Stifel Nicolaus in Baltimore. "You had a lot of players sitting on their hands. Overall, we were looking for a catalyst."

Short-sellers often will watch the CBOE Volatility Index for clues about how jittery the market is.

While the VIX is well off its historic highs during the worst of the financial crisis, it has held pretty well above 30, considered an important psychological number to show that volatility is in play. That type of environment is key for short-term traders who count on market gyrations to make money.

"Significant changes in short interest appeared to be centered around specific companies, rather than industries," analyst Jason Gurda, of Leerink Swan, said in a research note. The firm analyzes the health care sector and said the month saw dramatic increases in some companies.

Universal Health Services saw a 152 percent increase in short interest, which Gurda attributed to hedgers looking for protection should the company's acquisition of Psychiatric Solutions hit share price.

To be sure, it's important to remember that not all short positions automatically indicate a market belief that the company's shares are going to fall. The trade also can be a simple hedge against a bullish bet elsewhere.

In fact, some view an abundance both of short-selling and puts, or the bearish options that allow investors to sell shares at a certain price, a contrarian bullish indicator.

"The options market is extremely scared and they're also extremely hedged," Ryan Detrick, chief technical strategist at Schaeffer's Investment Research in Cincinnati, said in a CNBC interview. "They're willing to pay any price to have that protection. When there's too much worry, too much concern, more than even during the financial crisis...there's a lot of positives."

The leaders in short interest for May weren't terribly unusual, with Citigroup , Ford and Fannie Mae holding the top three short spots on the New York Stock Exchange.

Sirius XM , Level 3 and YRC Worlwide were the top three on the Nasdaq tech barometer.

YRC also saw the second-biggest increase in short interest on the Nasdaq as the company narrowly escaped bankruptcy last year and is a leader in the volatile trucking industry.

Traders also have been showing interest lately in battered oil giant BP and its involvement with the worst oil spill in US history.

Short interest was up nearly 20 percent Friday, according to ShortSqueeze, even as the stock rallied for the second day in a row.

"I don't think anybody out there thinks BP is a $30 company," Wiggs says. "It's either zero or 50. My personal bias is it's probably 50."

Citi, meanwhile, still held the top NYSE short spot even though it was the exchange's largest decliner for the month with a drop of 4.5 percent in short interest.

US-traded shares of Itau Unibanco saw a 375 percent short increase after Bank of America sold off the bank as part of an effort to shed its Latin America holdings. Health care giant McKesson saw its short interest soar 616 percent on the NYSE.

On the Nasdaq, Palm, Comcast and Microsoft saw the biggest declines in short interest. On the NYSE it was Dynegy and Tyco joining Citi as the biggest decliners in shorts.

Intel showed the biggest increase in short interest on the Nasdaq, with a surge of 36 percent, followed by Level 3 and YRC.

While the short game worked well in May, traders with bearish bets might want to belly up to the bar soon.

Even the most pessimistic forecasters who think the market is entering a full-blown bear phase expect it might not last long as the Standard & Poor's 500 shows support at 1,040 and the market's summer blahs dissipate in September.

"The overall feeling is this is a correction, not a double-dip," Wiggs says. "People are hesitant to put the big double-dip trade on. Everyone is expecting to see a bottom."

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CMCSA
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MSFT
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VIX
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