Half of this story was published yesterday. Read part 1 here.
At the end of part 1, our trapped hero had somehow pulled a rabbit out of his hat and explained to an expectant audience how short selling a stock works, and why investors need not always worry when short selling occurs in a stock they are invested in. Now an even more interesting aspect of short selling is revealed in answer to the kindly senior citizen’s last question:
“I get it. I’m not worried anymore! It’s unlikely that short sellers alone can kill a company that wasn’t already scheduled for termination from its own folly. But give us the frosting on the cake. Has the price of TSLA risen due to a short squeeze?”
“I can’t say. It’s hard to believe that short covering hasn’t had an effect on price because the shorts have been perennial losers in the stock. But it’s hard to quantify how much a short squeeze is playing a role in the stock’s current price. What we do know, however, is that the shorts have lost the battle to send the stock’s price to zero.
“Whoops. I’m afraid we’re nearly out of time. How about one last question.”
The Wendy’s lady doesn’t even bother raising her hand this time. From her seated position, she calls out, “How can we tell when those rascally short sellers are on the prowl?”
“That’s a great question because in addressing it we can also look at the trigger that sets the shorts pants on fire. Although it’s not easy to determine how many shareholders are lending out their shares, there is another tool to help determine what the shorts are up to. It involves options trading. We don’t have time to go into the mechanics of this type of derivative, but in brief, just think of options as a side bet on what the price of an underlying instrument — be it bushels of corn or shares of a stock — will be at some point in the future. Options trading incorporates three elements of the futures contracts we’ve discussed; there is a buyer and seller, there is a time factor (an option always has an expire date), and there is leverage. Recall that the buyer of the corn contract only had to put up a small deposit (perhaps 10%) of the value of the contract. That’s leverage. In options trading, the leverage is even greater because for a relatively small fee the option buyer is guaranteed the right to buy (or sell) a given quantity of shares at a given price. Such a model draws in a lot of players hoping to become rich PDQ. You can be sure the shorts are all over options trading when a company is perceived to be dying.
“Importantly, unlike shares issued by a company, of which there is a finite supply to borrow, an infinite number of options can be created. All it takes is a party willing to write (create) the option, and a party willing to buy that option. Someone expecting the price of a stock to rise in a given period of time can purchase a call option (go long), and someone believing the price will drop over time can buy a put option (go short). Think ‘put down’ when you hear the word put. That will help you remember the difference.
“The number of open put and call options (the open interest) on a stock are made public. To now answer your question, the short sellers are revealed by looking at how many put options have been created versus how many call options have been created. It’s expressed as the put/call ratio. For example, if there are 10,000 put options open and 5,000 call options open on a particular stock, then the put/call ratio is 2:1, or simply, 2. Conventional wisdom has it that when the put/call ratio is greater than 1 (more puts than calls) it is considered bearish for the stock.
“HOWEVER, it has been observed that when the put/call ratio reaches an extreme, it can be an indicator of a short squeeze potential. It means a lot of shorts have come out of the woodwork to bet that the price of the stock is heading down. And we’ve learned what that means if the market instead turns up. The extreme bearish sentiment leaves the shorts vulnerable. If someone lights a match to all that kindling — meaning the stock’s price gets bid up — then the shorts may very well go up in smoke. The more people in the building when it catches fire, the harder it is to get out.”
Before the Wendy’s woman can open her mouth, you’re responding to her question. “So, what lights the match, you ask? It’s what we’ve been talking about. There are those contrarian investors that rely more on extreme market sentiment than on fundamental analysis, technical analysis, or any other market indicator. The contrarian philosophy is based on the notion that an extreme majority of the people are never right. When investors overwhelmingly think the market will do A, the market will often surprise them by doing B. When all the newsletter writers turn bearish and hate the same stock, when the priesthood of market analysts pop onto the financial network and administer last rights to the stock, when the frenzy of gloom and doom is at its zenith … the contrarians are in there buying with both hands.
“If you are interested in timing your entry to go long a stock, or adding to your position, you might want to watch for a historically high put/call ratio. It may be a sign that the stock is about ready to move another leg higher.” (This is not advice. It is a suggested area of research.)
“For example, Schaeffer’ Investment Research posted an article in mid-September of last year suggesting that a record number of put options were being bought in relation to call options on TSLA … quoting a put/call ratio of 1.34 using its proprietary indicator. At the time, TSLA was trading just under $200 a share. The publicly calculable overall put/call ratio for the stock was 1.26 the day the article was published. Indeed, TSLA did dip a bit over the next two months. But during that period, the put/call ratio continued to rise, topping at around 1.7 in late November. That’s 1.7 bears for every one bull, which is approaching extreme (imbalanced) sentiment. As the below chart indicates, in early December, market sentiment flipped on TSLA and it was POW, right to the moon Alice.
“Bottom line, I’m not telling you that TSLA is going to rise further. Nobody knows that. I’m telling you that history demonstrates that the shorts can sometimes be the longs’ best friends when, as a whole, they get greedy.”
More applause break out. The attendees are on their feet. A couple of cat whistles are heard from the back of the room.
To wind down the crowd, you impart a last nugget of wisdom that has nothing to do with stock analysis, yet it applies perfectly to Tesla. … You say, “It is not wise to bet against an idea whose time has come,” and step away from the podium.
Now your phone is lighting up with text invites to dinner. Life is good again.
Recommended reading: Nobody Knows Anything: Investing Basics: Learn to Ignore the Experts, the Gurus, and other Fools, by Robert Moriarty
Disclaimer: The author holds no positions in TSLA.
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