August 22, 2002 Shorts Hold On Is the current rally in stocks being driven by short covering?

Part of the reason why bear market rallies are so spectacular and convincing is because of short covering: as short sellers lock in profits, or in some cases scramble to cover, even tiny amounts of additional non-short buying can help propel market prices quickly higher.

The recent stats from the NYSE suggest that either shorts did not cover during the late July spike higher in the markets, or they had previously (July 11-July 24) acquired extra massive short positions and covered only part of these positions.  Admittedly, the data is vague because it is only released on a monthly basis (more often than not it is rumors and/or people on the floor have a better sense for when shorts are scrambling to cover than the data later reveals).

Whatever the case may be, there is currently a record amount of short interest on the NYSE, both in terms of total shares short and as a percentage of all outstanding shares. It is worth remembering that just as many investors panicked and cut their losses in late July because prices were dropping, the same thing can happen to many shorts if prices continue to rise. What is also worth remembering is that the data is only current as of August 12. As such, if short interest posts a sharp decline at this time next month we may discover that the current rally has been underpinned by unlikely sources: namely covering short sellers, who many people believed had become exhausted after the markets ‘bottomed’ in July.

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