Bears “sell short” stocks they think are overpriced. To do so, they borrow stock from a broker and sell the shares, hoping to repay the loan with cheaper shares in the future.
Several studies have shown that stocks with high or rising levels of short sales underperform the market for two years or more. The stock exchanges report short sales of traded stocks towards the end of each month, so investors should keep track.
Thus, you might want to sell a stock if it has attracted the attention of short sellers, especially if there is no merger arbitrage that might account for short sales. Generally, short interest as low as 1 percent of all shares outstanding can be a warning sign for companies without listed stock options.
Short selling of companies with listed options is more common, as financial institutions hedge their options exposure. Nevertheless, if you hold a stock on which options are traded, short interest above 5 percent is a red flag.
Rising short sales of stocks with generous dividends are also danger signals. Such activity indicates that short-sellers are so pessimistic about the company that they’re willing to pay the dividend in order to cash in on the expected drop in the trading price.