How to Play a Heavily Shorted Market

Lee Adler

The market-reversing "Magic Hand" appeared again Monday, just when it looked as though all was lost. Is this the bottom?

One thing is certain: There is a crucial support area from 2,590 to 2,630 on the S&P 500 (see the chart below). On Monday it was stretched beyond the limit, when suddenly, out of nowhere came the Magic Hand.

In this instance, the bulls can thank the shorts again, because with liquidity tight and getting tighter, there's not enough intrinsic demand for stocks to mount a massive, lasting rally. But in a market that has become thin because prices have crossed the same range over and over, short covering can drive a fast rally – but only until the short covering exhausts itself. And those times are getting shorter.

Nevertheless, when the earth is in its final hours, with the core about to explode and obliterate the last remaining vestiges of life, there is one thing that you can count on.

The shorts will cover.

I remember the old saw of the ancient, white-haired, wise-men traders I sat with in customers' galleries at Walston & Company back in the late 1960s and early 1970s, when bear markets were the rule: "He who sells what isn't his'n, must buy it back or go to prison."

And short sellers have hair triggers. Once they see that support isn't breaking down, they pile in all at once to cover their positions. That also tends to pull in a few long-side buyers who have cash. They're in short supply now, however.

Ultimately, each of these short-covering rallies weakens the market because they deplete the demand that is coming from short covering. So, what about short interest today? Will it continue to drive rallies every time support is threatened?

Examining Primary Dealer and customer shorts gives us some obvious answers…

Look at What Just Happened

But first, let's look at what happened on Monday. The market plunged and threatened to break important support around 2,590–2,600. In fact, it did momentarily in the middle of the day. Then the Magic Hand appeared and stocks reversed. Once it was clear that the support break had whipsawed – roughly about the time the S&P rose back above 2,600 – the buying, most likely by shorts anxious to protect profits, really kicked in.

click to enlarge

That led to panic buying in the futures overnight. That caused a big gap open in New York. Normally, I'd look for a move to a 50% retracement of the sell-off that started last week. That would take the S&P 500 Index (SPX) to around 2,690, which would be in the middle of the recent range.

I would not buy more puts on the SPDR S&P 500 ETF (NYSE Arca: SPY) there just yet. I like to think of trading in mid range as being akin to a piece of beef in a meat grinder; I would not put my hand in. If the S&P hangs around that 2,690 area, it will probably make a run at the big downtrend line now in the 2,780s. If it rolls over around or below 2,690, then the rout may be on. I would definitely want a stop at 2,700 though, just in case the meat grinder gets turned on.

There Are Shorts, and Then There Are Shorts

Now what about the short interest? Looking at the Primary Dealer Shorts versus their customers, the trends are ominous. The dealers are shorting relatively more, and the customers – the bulk of whom are big institutions and hedge funds – are shorting relatively less. Guess who is usually right?

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Customers were skeptical of the bull thesis in early 2016, as they increased their shorting early in that rally. They continued to increase their shorts after Trump was elected, until January 2017. They then became believers in the bull case, and their short covering from April 2017 on helped fuel the final stages of the bubble.

This is weekly data, issued with a lag of nine days. It is of no use for short-term timing. But the point here on this chart is obvious. The institutional customers of the Primary Dealers still believed in the bull thesis right through Nov. 28. Their bullishness can be measured by the drop in their short positions to the lowest level of the two years on this chart, and even including 2015 (not shown), when their short positions were even higher.

In the recent air pockets in the market in October and November, they reduced their shorts even more. This means that there will be even less potential short covering to fuel future rallies.

Lee Adler

About the Author

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Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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