Stay away from these top 10 shorted stocks

Shorting, also known as "to go short" or "short-selling" is one way investors can profit from a decreasing share price. Short selling is essentially the opposite to the long-term 'buy low, sell high' strategy, whereby the investor aims to sell shares at a high price and repurchase them later at a lower price, profiting from the difference.

The process is as follows:

• The short seller identifies a stock they believe will drop in price in the coming months.
• An owner of the shares is approached and offered a cash fee (usually 0.3%-0.5% of the price) to allow their shares to be borrowed by the short seller.
• The shares are then sold and the proceeds received by the short seller.
• At some time in the future, the shares are then re-purchased by the short seller and transferred back to the original owner.

Short sellers make money when the value of the re-purchased shares is less than what the original shares were sold for, plus fees. Because of the risks and small market involved, short selling is a highly regulated and specialised investing market, with participants usually well informed of potential corporate news and company health. As a result, investors may use shorting statistics as a means of determining future market trends.

ASIC publishes short position statistics at a three-day lag to the market from 2010 onwards. Table 1 shows the top 10 shorted ASX-listed stocks and their % of free-float shares shorted on 20/9/13 and 21/10/13, and the change over that time.

Table 2 shows the 10 stocks that have seen the greatest increase in short positions over the past month.

There are a few interesting themes to takeaway from the two tables above.

1. Cochlear (ASX: COH) is now the most shorted stock on the ASX by percentage of free float stock, with shorts having increased by 30%, from 12% to 15% of stock, in the past month. This is most likely a result of short sellers believing that there are more downgrades to come from the company. Cochlear is losing market share as regulatory delays to the approval of its next generation hearing aid are taking longer than some expected. Cochlear's newest offering is also less superior than its competitors', potentially leading to the company losing some pricing power if medical professionals fail to adopt the new technology.

2. News Corp (ASX: NWS) has seen shorts increase from under 1% of listed stock to over 8%. The share price has risen recently, however reports that the cost to the company of the phone hacking scandal could reach in excess of $1.6 billion may be behind the short increase. This compares with $448 million previously reported.

3. Retail and mining services companies continue to be in favour with shorters, with 7 out of the top 10 from the two sectors. Myer (ASX: MYR), David Jones (ASX: DJS), and Metcash (ASX: MTS) stand to lose out if the domestic economy does not pick up and the Australian dollar remains high. Similarly, mining services and construction companies such as Monadelphous (ASX: MND) and UGL (ASX: UGL) will struggle in a subdued economy, while continued weakness in the gold price and poor operational performance has justified short interest in Kingsgate Consolidated (ASX: KCN).

Foolish takeaway

The short position information available from ASIC can give investors an idea of the negative sentiment surrounding a stock, but a high percentage of sold short shares does not guarantee poor performance. A rise in the share price can force short sellers to buy up shares to cover their positions, further increasing the share price and delivering quick returns for investors willing to accept more risk. Conservative investors may be better suited understanding the trends in the statistics, such as a high amount of shorting in particular sectors, in order to make investment decisions.