How tax-related short covering can lead to gains in the first week of a new calendar year
Shrewd investors can delay paying taxes on profits by a year if they wait until January to sell off their winners. Short sellers who have made money, likewise, can wait until the New Year before covering their shorts. If this phenomenon is prominent enough, then we should be able to identify some potential short-covering rallies at the beginning of the New Year. Below, I'm looking to see if these tax-related short-covering rallies show up in the early year data. If so, we might be able to find some profitable opportunities early on in 2019.
Short-Covering Returns the First Week of the New Year
First, I want to find out if any short-covering rallies are detectable in the data. What we're looking for are stocks that are heavily shorted in which the short sellers have a significant profit.
For the study below, I considered stocks with at least 20,000 total open interest. I looked back at 2017 and separated out the stocks that were heavily shorted (defined as stocks with at least 10% of float sold short). Then I grouped the stocks by those that were down 10% or more, those down less than 10%, and those that were positive. Based on the theory described above, those stocks that are heavily shorted and down significantly for the year (where short sellers theoretically have a healthy profit) should rally early in the next year as those shorts get covered.
The table below summarizes the stock returns in the first week of 2018. There's a strong case that these short-covering rallies are, in fact, discernible. In any study like this, finding stock returns at a certain point going forward, I think the best indicator for finding the strongest stocks is to look at the percentage that beats a broad-market benchmark. The bolded column is the column of highly shorted names that were down a lot in 2017. During the first week of 2018, 52.4% of these stocks beat the broad-based SPDR S&P 500 ETF (SPY), which is better than any of the other stock groupings.
For this study, another important data point is the average positive return. If our theory is correct, then the stocks getting covered should see some extra upward pressure compared to other stocks. Again, the stocks in that first column lead the way by this measure.
The average return for these stocks also beat the other groupings. The percentage of positive returns is one data point that might be of concern if you're trying to spot potential short-rallies; 68.3% of these stocks were positive the first week of the year, compared to 77.0% of stocks that were positive in 2017. In other words, you would have had a better chance at finding a winner by looking at stocks that were technically in better shape. Therefore, this indicator might be best for option players who especially benefit from violent short-term rallies, or it might be a confirmation indicator for those considering playing a technically weak stock.
Below is similar data using the same methodology, but going back to the year before. I looked at stock performance and short interest through 2016, and then found the returns of those stocks in the first week of 2017. This time, those beaten-down, heavily shorted stocks did even better compared to other stocks. About 70% of these stocks beat the SPY ETF, which is a lot more than any other stock grouping. The average positive return also easily tops the other groupings.
Short-Covering Returns the First Month of the New Year
Before we look at a list of stocks set to benefit from possible tax-related short covering in early 2019, I want to point out one more thing. The table below uses the same methodology for the most recent year (first week of 2018 returns based on 2017 performance and short interest), but it looks at the returns over the first month instead of the first week.
As it turns out, that same group of stocks that did well in the first week of this year doesn't look so good when you look at a longer time frame. While 52% of the stocks beat the SPY in the first week, just under 29% of them beat the SPY over the first month. The average positive return in this group also lags the other stock groupings over this time frame.
Looking at the one-month returns the year before (in 2017, based on 2016 performance and short interest), those heavily shorted weak stocks did better than the other groupings in some of the stats -- but remember (per the relevant table above), these stocks had a huge head start. In the first week, they averaged a gain of over 6%, but in the first month their average was just 4.25%. Therefore, on average, they lost value after the first week through the rest of the month (the SPY gained about 0.5% in that time frame).
This implies that any tax-related short covering is done very early on in the New Year. The rally is very short-lived, and once the covering is complete, these technically weak stocks quickly come back down to earth. In other words, if you're looking to profit from this phenomenon, you must buy in before the New Year or very early on in 2019.
Potential Short-Covering Rallies in 2019
Finally, the most important part. Below is a list of stocks that are down at least 10% in 2018, and with at least 10% of their float sold short. I also have some liquidity criteria of open interest and market cap. As options traders, we're especially interested in finding stocks able to make quick movements.
We also focus on option prices, so I sorted the list of stocks by our Schaeffer's Volatility Scorecard (SVS), which gives a higher score to stocks that have tended to move big compared to what their option prices predict. Based on the analysis above, these stocks should have a higher probability than normal to spike big in the first week of 2019.
