November 20, 2013

The Long and Short

In the timeless 1987 movie The Princess Bride, Vizzini the Sicilian, played riotously with a lisp by Wallace Shawn, keeps declaring things “inconceivable!”

Swordsman Inigo Montoya, portrayed then by Homeland’s Mandy Patinkin, finally says, “You keep using that word. I do not think it means what you think it means.”

You could say the same for short interest. It’s not what you think it means. Stay with me to the end, and you’ll see.

On August 2, 2012, Knight Capital Group’s algorithms failed. Monday at TABB Forum, Anthony Masso, CEO at trading risk-analytics provider Succession Systems, described how the SEC’s recent settlement with Knight successor KCG Holdings clarified a risk standard called the Market Access Rule. It requires brokers to have systems that forestall actions that may imperil themselves or others in the market. I’d paraphrase the law this way: “We order you to take whatever actions are necessary to prevent bad stuff. Thank you.”

That’s not what got my attention. The settlement reveals details about Knight’s errant trades. The broker bought, or went long, $3.5 billion of stocks; and shorted, or sold, about $3.2 billion. In less than an hour, its systems executed four million trades in 174 different stocks to create these positions.

This one tidbit is a tumbler unlocking vast secrets about market behavior. Knight’s algorithms were observably designed to build long and short positions of similar size principally to supply the storefronts of the stock market. When these positions failed to modulate, markets rushed into the vacuum, crushing Knight’s balance sheet.

Here’s the delicate balance in proprietary high-speed trading. Get it wrong by less than 10% and you’re done. Knight got it wrong. This same fragile trestle trains markets over the chasm each day. We’re all riding the rail.

ModernIR tracks short volume using algorithms. The daily average the past 50 days marketwide is 41%, not far off long/short equilibrium. Combined volumes on exchanges and dark pools total about 6.3 billion shares daily, meaning 2.5 billion shares each day are short.

Short interest in the S&P 500 is nearer 5% on average, though components can reach levels that roughly match daily short volume. The difference between interest and volume is that volume is just borrowed, while interest remains sold and outstanding.

Our data show that 11% of public companies have short volume above 50% of total volume. The highest in our client base the last five days was 61%. We’ve seen levels reach 85%, meaning nearly nine of every ten trades involved short shares – rented trading inventory. The lowest we saw was in a series of Class B shares trading just a few thousand per day where still 15% were short.

Elevated short interest can mean speculators are betting on a downturn. But it could as well be searing daytime demand for trading “inventory” – bowling shoes to put on for the day, for the game, traders and intermediaries finding renting cheaper than owning.

What concerns me is that short volume by definition in Regulation T is credit. So the market is heavily dependent on borrowing, just like the entire global financial system.

You have to see volume differently. Half of it is borrowed. Rented. Bowling shoes. High short interest is a product of frenetic demand on short horizons – not a certificate guaranteeing imminent pressure.

But realize that a hiccup in long/short balances can move your shares sharply – and it’s got nothing to do with ownership, or even shorting in the conventional sense. Inconceivable? No. And you know now what I mean.

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