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Short Interest Reflects Trader Sentiment

By Bryan Perry

Markets fall faster than they climb -- something many investors have been harshly reminded of lately. And when stocks and indices start dropping, many investors cash out and wait for better days. But is there a way to stay in the markets and maybe even initiate some new plays to take advantage of the chaos that has sent everyone else running?

That answer is yes. The advantage of options trading is that you can profit even when stocks are sliding. But in an up-one-day, down-the-next environment, it can be difficult for traders to discern where the indices are going and whether it's time to buy calls or puts.

Although a market is trending downward, do you want to buy put options to bet on further downside, or do you take the glass-half-full outlook on market events and buy calls instead?

No one has a foolproof methodology or a crystal ball to predict where a market will trend and when it will happen, but one factor that nearly all options traders value for indicating longer-term market direction is short interest.

Shorting, of course, is the reverse of buying stocks, and it entails selling a security that you don't own with the expectation that the price will fall. It requires borrowing shares from your broker, and the play is closed when you buy the stock on the open market -- preferably at a lower price. Then you can return the stock to your dealer and pocket the gain. This is what makes short-selling a potentially lucrative -- albeit risky -- trading strategy.

Short interest shows the total number of shares of a stock that have been sold short on the open market by investors but have not yet been "covered" or closed. Understanding what short-sellers are doing means options traders can gauge overall market sentiment surrounding a particular stock or sector.

Let's say that Crocs' (CROX) short interest increased by 20% in one month. This means that there was a 20% increase in the number of people who expect the stock to fall.

Now, if you were thinking about buying the stock to hold for the longer term, knowing that Crocs' short interest had grown so significantly might keep you from buying -- and likely losing money on -- the stock in the short term.

But as an options investor, you can use that information to make money by establishing CROX put option positions in anticipation of the stock's pullback.

That is, instead of risking life and limb to short the shares, you could instead buy put options at a fraction of the risk and cost and still have a bearish bet on the company!