Decide When to Buy or Sell Using Short Selling Activities

Note: This feature is not available anymore due to licensing issues.

Here is a question: How do you decide when to buy or sell a stock?

I started trading in SGX a year ago, and every time I have money to invest, I always wonder “Should I buy now? But if not now, then when?” Since I didn’t have a good answer to that question, what I’ve been doing till now is simply buy the best stock that fits my portfolio whenever I have cash.

That was the best I could do then, but I believed there must be a better way to do this and have been thinking about it. One idea that recently took form is using short selling activities to identify a good entry point to buy.

To give a quick illustration of what short selling is, imagine that A borrows a book from B.
A then sells the book to C and gets cash on the spot.
But A has to return a book to B within a certain time limit, so A has to go out and buy one.
Now, replace the book with stocks and you have a simplified overview of A carrying out short selling.

The idea is this: If someone short sells a stock, he is pessimistic about the near future of the stock and is betting that the stock price would fall in the near future. Another side effect of short selling is that it creates a real demand in the near future because some day, and typically soon, short sellers need to close their position by buying.

Therefore, if there is a sudden surge of short selling activities, firstly, it would push prices down due to increased selling and more importantly, it would also suggest that in the near future, the price will rebound due to the demand created from all the short selling (remember, all the short sellers will soon have to buy).

Therefore, I have created two tools to monitor short selling activities:

1) Graphs to look at the short selling activities visually
As an example, let’s look at the STI short selling activities graph. You can see the phenomenon that I mentioned earlier occurring a few times: STI drops significantly as the short selling activities surges, but soon after, the index recovers rapidly.

ShortSellRatio 20 is the percentage of transaction values that are of a short selling nature in the past 20 days. ShortSellRatio 200 refers to the past 200 days, which would give us the long term baseline. When ShortSellRatio 20 is above ShortSellRatio 200, this means that there is an increase in short selling activities in the short term.

2) An indicator to gauge market sentiment
For people who prefer numbers over graphs, I added a ShortSellRatio Sentiment. Mathematically,
ShortSellRatio Sentiment = (ShortSellRatio20 / ShortSellRatio200 – 1.0) x -100

In English, it means how optimistic or pessimistic the short-term (20 days) is relative to the long-term (200 days). Positive values would indicate optimism and negative values indicate pessimism. For example, a +20% would mean that the short selling activity is 20% lesser than usual, which indicates that it is 20% more optimistic than usual. This page gives a quick overview of the optimism or pessimism of stocks.

While using short selling activities may not be able to help us perfectly time the market, I believe it is a useful gauge to know which point of a cycle we are currently at – optimistic or pessimistic.

As usual, I am happy to hear feedback especially on what you use to gauge market sentiment, or more specifically, how you decide when to buy or sell.

Happy investing!

Edit: Links in this article are no longer working because of licensing issues. My apologies. Read this article for more information.