By Phil Mackintosh, Chief Economist, Nasdaq
Short squeezes are nothing new. But recent action in some heavily shorted stocks over the past weeks has brought the topic to the fore again.
One thing many people ask is: How can a stock be more than 100% shorted?
Being 100% shorted doesn’t mean there are zero net investors in a stock. In fact, it means the opposite. Here is why.
Before you short, you must borrow stock
In the past, when you bought a stock, as you handed over your cash, the seller would give you actual share certificates to prove your ownership of the company.
These days that is all electronic, and shares are “held” by a custodian, but the rules work the same.
Reg SHO requires those who want to short sell a stock to arrange to borrow the stock from a long holder first. Even though settlement doesn’t happen until two days later (T+2). This:
- Minimizes the risk of failed trades.
- Ensures stocks can only be shorted when there are holders willing to loan their stock.
- Adds costs to short selling (collateral and holding costs) that make it expensive to hold a short indefinitely.
Chart 1: Before you short, you must borrow the stock from a long holder
SOURCE: NASDAQ ECONOMIC RESEARCH
So how does a stock get 100% shorted?
Many fear that a stock with 100% short interest actually has zero net investors left. In fact, the opposite is true. The higher the short interest, the more long investors there are. Here is how that happens:
All companies have a set number of issued shares that rarely changes. That’s one reason index funds don’t need to trade very much. With no short interest, the holders of all the outstanding shares equal the “long investors” (Chart 2).
Chart 2: Very few stocks have no short sellers, as market makers and arbitrageurs will short stocks to provide liquidity to buyers and hedge their positions
SOURCE: NASDAQ ECONOMIC RESEARCH
However, there are a number of good reasons short selling is allowed, including futures and ETF arbitrage that ensure investors get more accurate prices and more access to liquidity regardless of how they buy equity market exposure.
In order to establish a short position, the short seller must first arrange to borrow the stock. That is done so that when the short seller comes to settle their trade, they have stocks to deliver to their buyer (Chart 3). Stock loans aren’t unique to stock markets. In fact, a mature “repo” market is what helps bond markets function efficiently, even when off-the-run liquidity is low.
Chart 3: A short seller must arrange to borrow stock
SOURCE: NASDAQ ECONOMIC RESEARCH
Then, a short seller will enter the market to short a stock that they consider “richly valued.”
Importantly, their short position isn’t established until they trade with a buyer. Most often, that represents a new buyer of the stock, expanding the long interest (or exposure) to the stock (Chart 4).
Chart 4: When a short seller finds a buyer, their trade establishes their short position
SOURCE: NASDAQ ECONOMIC RESEARCH
The important fact here is that an increase in short interest results in a greater number of long investors (not fewer).
The way short interest increases toward 100% (or more) is through more of the same mechanism. If more short sellers can find long holders willing to lend stock, as well as additional new buyers of the stock, they can establish new short positions. Ultimately, a stock with 100% short interest actually has 200% long interest (Chart 5).
Chart 5: With enough buyers willing to lend and sellers wanting to short, short interest can increase to 100% (or more)
SOURCE: NASDAQ ECONOMIC RESEARCH
Stock loans increase investor returns, add costs to shorts
In the diagram above, we show that all buyers are able to lend stock, even those that received lent stock in the first place (long investors with dotted outlines). This was the case even when trades were settled with physical certificates.
Importantly, when a long holder decides to sell a “loaned” position, they will need to recall that loaned stock first, so they too have stock to deliver to the new buyer on settlement. That will cause short sellers to find another loan or, if not available, close their short. That means buying the short position back, sometimes known as a “short squeeze.”
The fungibility of long and loaned stock is important. Any long holding can be lent, and a long holder can recall stock from any borrower, saving them having to track down the specific shares they originally lent.
That in turn helps reduce failed trades.
It also makes all sellers economically equal. That’s because all investors are able to benefit from the income earned by lending their stock, increasing the potential returns and value of their “lendable” purchases. If only some stock holdings were able to be loaned, investors would want a discount for non-loanable stock, and we would need two different markets for each ticker.
For a short seller, there are additional costs created by borrowing stock:
- Fees are paid to the lender, typically per day, which increases the cost of holding a short for a long time. Market forces usually mean that the more traders short a stock, the more demand there is for borrowing, which can push the cost of borrowing stock up. It’s not uncommon for “hard-to-borrow” stocks to cost more than the prevailing Treasury bond interest rates.
- Short sellers must also post collateral, typically worth more than the borrowed stock, so that the lender is protected from default risks, even if prices on the lent stock rises. Margin calls are also possible if the price rises above the level of initial collateral.
These costs create an additional hurdle for short sellers to achieve positive returns. It explains wider spreads in less liquid ETFs and limits how long large positions are typically held.
Special rules restrict short selling, especially in selloffs
There are rules that limit short selling, especially during volatile markets. We’ve already talked about how Reg-SHO requires all short sales to locate borrowed stock before they trade, so they won’t fail settlements.
If a stock does start to see failed settlements anyway, borrow restrictions automatically become tighter, as the stock is placed on the threshold list.
Reg SHO also automatically changes how trading works in volatile periods, like we saw during the COVID selloff in March 2020. For any stock that has fallen 10% on either of the past two days, short sellers cannot sell at the bid. That stops short sellers from pushing prices down further. Known as the “bid test,” it requires short sellers to instead offer stock in the market at a price above the current bid and wait for a buyer to pay their higher offer price.
The short story on short interest
It’s true that stocks can get to 100% shorted (or more). But as short selling increases, more long investors are also created. In essence, there are more long positions than shares outstanding – not less.
All trades have buyers and sellers, so selling is important to the market. Research overwhelmingly shows that short sellers add to market quality: tightening spreads, adding liquidity, aiding arbitrage and streamlining risk transfer. There is even evidence that they improve price discovery to levels that attract new buyers. That all adds to lower trading costs, which, in turn, help lower the costs of capital for issuers.
