Rally Catches Short Sellers by Surprise

Some of the buying on Wall Street this week is almost certainly coming from traders who would rather be selling.

The New York Stock Exchange said Thursday that “short interest”--the number of shares borrowed and sold in a bet that prices will drop--rose to a record 5.38 billion in the month ended April 12, up 7.2% from mid-March.

With short sales at record highs a week ago, this week’s heated rally in stocks caught many bearish traders by surprise, and undoubtedly caused some to cover their short positions by purchasing stock to repay loaned shares, analysts said.

Any such buying would have helped drive share prices higher in the rally--exactly the opposite of what short sellers want to happen.

In a short sale a trader borrows stock, usually from a brokerage’s inventory, and sells it in the open market, pocketing the proceeds. The bet is that the stock’s market price then will decline.

If the bet is correct, the trader’s profit is the difference between the sales price and the price the trader eventually pays to buy back the stock to repay the loan.

But if the stock’s price rises, a short seller can face unlimited losses until the bet is closed out.

Example: A trader who sold General Electric shares short on March 22 at $37.70--the stock’s closing price that day--now has a paper loss of $10.81 a share on the trade, with the stock at $48.51 at Thursday’s close.

That trader could maintain the short sale, hoping that GE’s shares fall again. But at some point, if the stock continues to rise, mounting losses on the short bet may force the trader to capitulate and repurchase the shares.

Indeed, one reason why some Wall Street pros now believe the market’s rally will continue for a while is that more short sellers are likely to close out their bets, adding to buying pressure in the market.

Short interest in Nasdaq stocks has yet to be reported for mid-April. But the figure for mid-March was a record 3.6 billion shares.