I got a call from my broker this morning asking me if I’d be willing to loan out my shares of Cree, Inc. (NASD:CREE) to a short seller. Since the only cost to me is that I will not be able to vote my shares, and I will earn 2.5% per annum on the value, I said "yes."
Normally, brokerages get the shares they lend out to shorts from margin accounts with a margin balance. Since I never carry a balance (although I do have a margin account in order to trade options) they must ask my permission and pay me interest in order to borrow my shares. I’m planning on holding these shares for the long term, so I’m happy to earn an extra 2.5% on my money. (I could still sell them, in which case the short seller would have to find shares to borrow from someone else, or cover his position.)
I also had the idea of creating some synthetic cash-covered short puts (a combination of the long position in the stock with short calls) to give me more shares to loan out, but the relative prices of calls and puts on Cree make this unattractive. Most likely, other arbitrageurs who are able to earn higher interest on their loaned shares have already pursued this route to the point where it is no longer attractive to me (my return on capital would only be about 8%; I can do better with a plain-vanilla cash-covered puts.)
What to Make of the High Short Ratio?
Cree’s short ratio (the ratio between the number of shares short to the company’s float, or shares available for trade) is an extremely high 26.9%, and has risen over the last month. This is why my broker was calling me to borrow shares. But, other than my opportunity to make an incremental profit on my shares, what does this mean for the future of the stock?
On its face, a high short ratio means that a lot of investors are bearish about Cree’s prospects. This can be good or bad news, depending on how likely the shorts are to be right. The contrarian position (and I usually lean towards the contrarian) is that most investors are usually wrong, meaning that a high short ratio is a bullish indicator. We also know, since I’m getting calls from my broker, that few new investors will be able to short. Finally, there is the potential of a short squeeze, which could be triggered by positive news such as another buyout rumor. Short squeezes can lead to radical price increases over short periods.
I’m taking the call from my broker as another moderately bullish sign.
DISCLOSURE: Tom Konrad and/or his clients have long positions in CREE.
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