Weak Shorts

What Are Weak Shorts?

Weak shorts refer to traders or investors who hold a short position in a stock or other financial asset who will close it out at the first indication of price strength. Weak shorts are typically investors with limited financial capacity, which may preclude them from taking on too much risk on a single short position. A weak short will generally have a tight stop-loss order in place on the short position to cap the loss on the short trade in case it goes against the trader. Weak shorts are conceptually similar to weak longs, though the latter employ long positions.

Key Takeaways

  • A weak short is a reference to a trader holding a short position who will exit quickly if the price starts rising.
  • Some bullish traders look to buy stocks with a high degree of short interest and weak shorts, hoping that pushing the price will cause a short squeeze where all the shorts have to buy and push the price up further.
  • Retail traders are more likely to be weak shorts than institutional investors, as the latter group is likely to have a larger financial reserve.
  • Retail traders may benefit from being weak shorts, as they can control losses, and get out if the price rises by a certain amount.

Understanding Weak Shorts

Weak shorts are more likely to be carried by retail traders rather than institutional investors since the retail trader's financial capacity is limited. That said, even institutional investors may find themselves in the weak-short camp if they are financially stretched and cannot afford to commit more capital to a trade.

The presence of weak shorts may intensify volatility in a stock or other asset because they will be inclined to exit their short positions if the stock shows signs of strengthening. Such short covering may drive up the stock price rapidly, which may force other traders with short positions to close them for fear of being caught in a short squeeze.

Subsequently, if the stock begins to weaken and again looks vulnerable, the weak shorts may reinstate their short positions. Weak shorts may be constrained by the availability of capital but may still have a high degree of conviction in their short idea. A heavy shorting activity would accentuate the stock's weakness, driving its price down quickly, a trading pattern that could lead to heightened stock volatility.

For a retail trader that is day trading or swing trading, being a weak short is not a bad thing. By exiting early when a stock no longer looks weak the trader limits their risk and saves their capital for the short trades that are acting weak and making them money.

Stocks or other financial assets that have a substantial weak short presence will often be more volatile than those with less of a weak short presence.

How to Bet Against Weak Shorts

Traders often look for stocks with heavy short interest, which is used as a contrarian indicator to identify stocks that may be poised to move up on a short squeeze. Stocks that are heavily shorted primarily by retail investors may be better short-squeeze candidates than those where the short positions are mainly held by institutions with deep pockets, such as hedge funds.

While short interest for a stock is provided on a consolidated basis and is not categorized as retail or institutional, one way to identify retail short interest is by using trading software that shows major holders of the stock and block trades. A stock with (a) minimal institutional holdings, (b) few block trades, and (c) significant short interest is likely to be one with a disproportionate number of weak shorts.

Traders can wait for the price to start strengthening, potentially moving above a key resistance level where lots of short-trade stop-loss orders are likely placed. A trader could initiate a long, anticipating a further rise as a large number of weak short traders are forced out of their position and buy the stock to cover.

Weak Short vs. the Put/Call Ratio

Puts are another way to bet on a declining stock price. The put/call ratio measures the number of puts bought versus the number of calls (which profit if the stock price rises). The ratio indicates when traders have become extremely bearish or bullish on a stock. This can be used as a contrarian indicator that a reversal in price may be forthcoming.

Limitations of Using Weak Shorts

It is hard to know in advance how weak shorts are. It is also possible that the shorts are short for good reason: the stock is falling. Weak or not, they are in the correct position to profit, and buying into them may be foolish.

Trying to force weak shorts out of a position, causing a price pop, may prop the price up temporarily, but unless positive news/fundamentals/technicals emerge, additional buyers may not enter and the price will continue to fall again.

Weak shorts are a conceptional theory. They can't be measured with great accuracy, therefore it can't be known exactly how many weak shorts there are or how weak they actually are.