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Short sellers betting Caterpillar will come back down to earth

Bloomberg reports that short interest in Caterpillar surged as traders bet the company wouldn’t get much of a bump from Obama’s stimulus package in 2009.

Short interest in Peoria, Illinois-based Caterpillar rose 25 percent to 27.5 million shares from April 30 through Dec. 31 2008, according to New York Stock Exchange data released this week compiled by Bloomberg. The increase follows Caterpillar’s 36 percent stock rally from a four-year closing low in October through the end of the year.

Still don’t know what short interest means? It’s pretty simple, actually: In a short sale, a trader borrows shares at one price, hoping he can return the shares at a lower price and pocket the difference. Example:

Trader Bob enters a short sale for 100 shares of Cat at $40. He borrows the shares in his brokerage margin account and sells them immediately for $4,000 in cash, which he now owes to his brokerage. A week later the market tanks and the shares go down to $35. Bob “covers” his shorts by buying 100 shares for $3,500 and returning them to the brokerage. The transaction leaves his account up $500 (though his net can be much less after subtracting commissions, interest and capital gains taxes.)

Shorts serve two essential purposes: discouraging companies from cooking their books (shorts love to go public with this information because it’s money in their pockets) and providing a ready group of buyers when the bulls are running scared. These control functions explain why the brokers will allow you to sell shares you don’t actually own.

Short covering typically triggers wild bear market melt-ups that illustrate the hazards short-sellers endure: Your profit ends when the stock hits zero but your losses are potentially infinite because there is no limit on how high a stock can go.

The infinite-loss potential ensures that short-sellers buy back their shares ASAP when their bets go bad: better to eat your losses at 20 percent than 2,0000. When large numbers of short sellers get caught on the wrong side of a market move, they all rush to cover en masse, creating a “short squeeze” that obliges them to buy every share they can get their mitts on today for fear the prices will be ruinously higher tomorrow.

Short squeezes are the prime culprits in the one-day wonders we see so often during bear markets. Because many journalists can’t quite grasp how you can sell shares you don’t own, they tend to underplay or completely ignore the role of short squeezes, which causes them to treat every 5 percent pop to the upside like the dawn of a new bull market.

Sooner or later the bulls have their day, but not until the bear satisfies his hunger and decides it’s time for a long winter’s nap. Short interest is a rough measure of the bear’s appetite.

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Tom Mangan posted at 12:17 am January 14th, 2009 |