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Twitter Burns the Bears

Short interest in Twitter (betting that the stock would fall) fell precipitously just before its recent decline. Twitter, the social media/messaging app known by its bluebird silhouette, raced up almost 40% to $25 earlier this month on takeover rumors. When the buyers failed to appear, its wings were clipped and it fell hard and swift back to $17. Unfortunately for the bears, they had removed a large chunk of their bearish bet just before the stock fell.

Such is the life of a short seller. I spent 25 years shorting stocks and this scenario is sadly familiar. While short sellers must be correct that the fundamentals of a stock are unwinding, it is equally, if not more important, that they be accurate on the timing of the short bet.

The abrupt rise of Twitter’s stock shows how just seven days of poor timing can produce a mountain of losses for a short seller. In addition, a short bet carries unlimited risk which can wipe out even the most experienced trader. For these two reasons subscribers of my Profit Catalyst Alert newsletter will see that I recommend put purchases on the stocks I am most bearish on.

The short interest in a stock is measured by the percent of shares trading that are sold short. For Twitter, the short interest fell from 7% of total shares on Sept. 22 when the stock was $23 down to less than 4% on Oct. 5 when it began its downward spiral.

Most traders, who were likely underwater with their bearish bets, were forced to buy back or “cover” as the stock raged upward and their losses mounted. This forced covering is often known as a short squeeze, a term sounding oddly affectionate but is morbidly painful for those on the receiving end.

Twitter has been a particularly difficult short. The company has lost anywhere from $79 million to $162 million per quarter since early 2014 and has never earned a dime. The stock traded on hype and dreams of future profits, an elusive hope for a company with geometrically expanding expenses.

Although a serial money loser sounds like a dream short, a stock like this can be most difficult for the bears. If the bulls are totally comfortable with Twitter losing money for an indefinite period of time, the bears had to look elsewhere for news that would disappoint bullish investors.

That number was revenue growth, which has slowed dramatically for Twitter. The stock’s biggest decline came in June 2015 when revenue growth dropped from 100% to 74%. Yet even after that drop the stock jumped 50% for a short period.

Luckily for the bears, the Chicago Board Options Exchange (CBOE) is continually adding longer term options (called LEAPS) and more frequent expiration dates for an increasing number of stocks.

Most shorts feel lucky if they can narrow down the timing of a stock’s decline to a two quarter period. With even the smartest analysts out there working with such a wide time frame, buying puts that expire 6 months out will often capture the expected plunge of a stock.

Like anyone who survives in the woods eating raw meat, most bears are tenacious and wily animals. Short selling is surely not for the faint of heart but with sharp claws and a cap on losses it can produce tremendous returns.

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