Keeping an eye on which ASX shares have the most short seller interest is a useful strategy for ordinary investors.

It’s useful because it indicates that something is wrong with the company you hold. That doesn’t necessarily mean you should sell that particular stock. It just raises a red flag for your attention.

As we explain over in our Education Centre, short selling is a strategy employed by professional traders and investors. It’s typically not available to ordinary ASX shares investors.

A short seller will short a stock when they reckon it’s going to fall in value. They essentially place a bet that the share price will fall, and if it does, they make money.

How the short sellers determine which stocks to short

At the Australian Financial Review Alpha Live conference this week, some of Australia’s highest-profile short sellers revealed four common red flags that typically can lead to them shorting a stock.

They are:

• Insider selling (i.e., directors selling a portion of their shares, which has to be disclosed to the ASX)
• Management exits from the business
• Frequent strategic reviews within the business
• Macro or structural headwinds, like inflation.

Perpetual’s deputy head of equities Anthony Aboud said:

It’s a combination of a couple of them plus a bit of debt. And the headwinds, whether macro or structural, and you’ve got a good probability.

Aboud said inflation was a significant pressure on some companies today.

And with interest rates rising, capital has become a much bigger expense for companies with a lot of debt.

As an example, Aboud said Downer EDI Ltd (ASX: DOW) caught his eye at the end of last year due to its weak share price, several management exits, and its debt levels.

Why monitor the short positioning on your ASX shares?

It’s worth monitoring the percentage of short positioning on your ASX shares because it can give you early clues that share prices are going to fall.

Remember, the pros spend all day researching this stuff, and they only place trades when they’re confident they’re right.

One reason a short seller may target an ASX share is a recent history of tremendous share price growth that goes above and beyond a stock’s intrinsic worth.

This can often happen with speculative ASX small-cap shares, which tend to ride waves of growth and decline as the companies grow and develop.

Holding these stocks when they’re on the rise can be great fun, but if you want to take early profits, it’s a good move to watch the short seller action on that stock.

When the pros begin to short sell a stock you hold, it may indicate it’s time to take your capital gains. If you’re considering buying the stock, it may indicate you should hold off.

Useful information, right?

Of course, it’s worth remembering that short sellers are trying to make money in the short term. If you’re invested in a stock for the long term, then short positioning may have less relevance for you.

As Aboud says:

You don’t want to talk yourself out of good opportunities on the long side because you’re so focused on what can go wrong.

It’s really important you make sure you balance that.

It’s also interesting to note whether short seller positions on a stock are rising or falling.

If they’re falling, this usually indicates the ASX share has also fallen in price to a more reasonable level, and thus, the pros are closing their short sell positions.

Let’s look at some examples of ASX stocks with significant short positions at the moment.

Which ASX shares have the most short-seller interest?

Every week, my Fool colleague James covers the 10 most shorted ASX shares.

As you can see in his latest report, the top 10 most shorted shares have about 8% to 12% of their capital (shares on issue) shorted. So, use this as a guide. This is a concerning level of short interest.

You’ll also see there are varying reasons for short-seller interest in each of these ASX shares.

For example, short sellers have been targeting ASX lithium share Core Lithium Ltd (ASX: CXO) for some time now. The short positioning is currently 8.9%.

One key reason is that Core Lithium shares had astronomical growth in 2021 and 2022. In fact, the stock became a 10-bagger in this short time frame.

Several brokers say Core Lithium is trading at a significant premium to its peers, indicating it’s overvalued at today’s share price levels and other ASX lithium shares offer better buying.

Zip Co Ltd (ASX: ZIP) shares have also been shorted for some time. The short seller interest is 10.3%.

The issue here is that the buy now, pay later company has gone through a major restructuring.

Instead of going for massive global growth as it did for many years, Zip management has scaled back the business. They are now focused on making a profit in just a few key national markets.

The pros aren’t convinced the company can reach its current goals, so they’re shorting the stock.

Fool takeaway

You can look up the short positioning on any ASX share you are interested in via ASIC’s short position reports page.

The post Short sellers reveal 4 ways to spot dud ASX shares appeared first on The Motley Fool Australia.

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More reading

• Here are the 10 most shorted ASX shares
• Here are the top 10 ASX 200 shares today
• Making it rain: Could this signal a boom for ASX 200 lithium stocks?
• Own Core Lithium shares? Here’s why the miner backed off its Tesla deal
• Why Adbri, Champion Iron, Core Lithium, and Syrah shares are dropping today

Motley Fool contributor Bronwyn Allen has positions in Core Lithium and Zip Co. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Zip Co. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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