Brief interest in the decline – Traders Magazine

By Phil Mackintosh, Chief Economist, Nasdaq

Stock activity even in January 2021 shed light on short selling, spurring an SEC report and new proposals for rule changes from the SEC and FINRA.

But what’s interesting when we look at the data is that short-term interest was actually down long before the MEME stock squeeze happened.

What is the difference between short selling and short interest?

Short selling occurs when a trader sells a stock that he does not already own. This is done by borrowing shares of those shares and (effectively) selling the borrowed shares in the market. When the short seller closes his position, he buys back the stock. Shares received in settlement are returned to the stock lender and loan collateral is returned to the short seller.

Short interest represents the total amount of shares sold short. Regulators require total short shares held in each security to be disclosed twice a month. Since not all companies are the same size, just looking at total shares doesn’t make for good comparisons. Instead, we typically compare short interest ratios which view shorts as a percentage of outstanding float (short float) or average daily liquidity (days to hedge).

Today we look at short-term interest as a percentage of shares outstanding (short-term float) over time.

Declining short interest

Over the past decade, median levels of short-term interest have been relatively constant. For example, typical (median) short interest on S&P 500 stocks has ranged from 1.6% to 2.9% (blue line in Chart 1).

Despite this narrow range, short-term interest ratios peaked in March 2016 for all enterprise size groups and have since generally declined. Interestingly, short-term interest in the S&P 500 fell the fastest right after the COVID-19 lockdowns, falling to around 1.6% in 2020, roughly in line with their current level.

Chart 1: Short-term interest has generally declined since 2016

Some of the short interest in S&P 500 stocks is needed to maintain arbitrage. S&P 500 stocks are the most liquid ETF in the United States, along with futures, which trade even more than the entire stock market with significant open interest. There are also liquid options markets on the S&P 500 index as well as swaps. A certain amount of stock shorting is necessary only to cover arbitrage positions against these index products.

Given this, it is interesting to note that typical short interest for large-cap stocks is about half of the normal short-interest levels for mid- and small-cap stocks throughout the period. Short-term interest on small and mid caps also remains above record lows for the Chart 1 period.

What about the best-selling stocks?

Of course, stock trading even in January 2021 was, at least initially, focused on a few very high short-term stocks. GME initially had a short interest rate of almost 100%, although as we explained, that’s not as short as it looks.

In Chart 2, we focus on the average short interest of the top 10 shorted stocks in each group. This shows a dramatic drop in the top shorted stocks in January 2021, likely impacted by the meme stock squeeze. For example, short-term interest in mid-cap stocks, which includes the majority of meme stocks, fell from 60% to 25% in just a few weeks.

Chart 2: Average short interest for the 10 best-selling stocks (in each group)

Average of the 10 largest short floats

It is also interesting to compare the left axis on the two graphs. Top-selling stocks have more of their market capitalization held short than the typical level for all stocks. For example, the best-selling S&P 500 stocks now have an average short interest of 11% of shares outstanding, compared to 1.6% for the median stock (in Chart 1). It also suggests that short sellers are primarily focused on just a few stocks.

Regulators take action

As markets have sold off due to COVID, several countries have banned short selling of certain stocks, despite research that consistently shows that short selling bans are bad for the market – spreads widen and liquidity decreases. Sometimes the inability to hedge makes the market sell more than when short selling is permitted. At the time, the US resisted, with former SEC Chairman Jay Clayton saying, “We shouldn’t ban short selling; you need to be able to be on the short side of the market in order to facilitate trading in the regular market.

However, the same equity trading in January 2021 has refocused regulators – particularly on stocks with high short yields. Since then, regulators have advanced many new investigations and proposals:

  • the DOJ East would have investigated professional investorslooking for signs that some companies might be staging stock declines or engaging in insider trading.
  • The Financial Sector Regulatory Authority (FINRA) offered more frequent reports to the public of short data of interest that it collects. FINRA suggests moving Rule 4560 from the current biweekly to weekly or daily, as well as shortening the timeframe for submitting and publishing short data of interest to the public.
  • FINRA has also proposed additional collection account-level data, including synthetic shorts (those that use derivatives), loan obligations resulting from stock borrowing, and daily non-delivery positions. However, this should be for their own monitoring of the SHO regulation, not public
  • the SEC GME Report concluded that “improved reporting of short selling would allow regulators to better track” the interplay of short selling and price hedging.
  • The SEC proposed a shorter settlement cycle. By modifying Rule 15c6-1, the settlement period would change to T+1. This would reduce non-delivery positions from a short sale closing date to T+2.
  • In 2021, the SEC proposed what is essentially a “strip” for stock lending. Known as the Exchange Act’s 10c-1 rule, it would require all loans of a security to be reported within 15 minutes to FINRA – including details such as issuer, symbol, time, location, amount loaned, securities lending fees, other fees, collateral used, and type of borrower entity. Information on securities available and on loan would ultimately be required; it would be aggregated and made public the next business day by FINRA.
  • the SECOND also voted to amend the CAT plan to require CAT reporting firms to report “buy to hedge” information to CAT, including indicating where shorts were a bona fide market exception under of the SHO regulation.
  • Last week, the SEC proposed a new short position disclosure rule. Proposed Rule 13f-2 and corresponding Form SHO would require institutional investors to report their short positions to the SEC on a monthly basis (14 days after the end of each month) if their gross position was greater than $10 million. The SEC would then make available to the public for each individual title.

The SEC’s latest proposal is somewhat similar to what is happening in Europe, where hedge funds are required to report short positions once they sell more than 0.1% of outstanding shares, compared to 0.2 % in January 2022, where the data is established. public when the shorts exceed 0.5% of the outstanding shares.

Interestingly, this is still not consistent with how US investors report long positions, which are mostly reported quarterly, by account, on Form 13F. Although the SEC at also proposed expanding US long position reporting to “examine” swap positions, which is similar to FINRA’s proposal to include synthetic short positions in their data collection.

Shedding new light on short sellers

Although research suggests that short sellers provide significant price discovery and liquidity to the market, recent trading activity has prompted FINRA and the SEC to offer more granular and frequent short sale reports.

These rules are not yet final, but the fact that they have been proposed marks a change from historical rules on short selling – even as total levels of short selling are on the decline.

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