shortside's  Instablog

Shares of Magnum Hunter (MHR) borrowed in the securities lending market have declined from 18.6 million to 11 million shares over the past week as short sellers have purchased shares in the market and returned them to institutional investors / lenders.

Despite this short covering which provided support to the share price, MHR has still lost almost 10% on the week.

Short interest stood at 18 million shares at the end of April, so we'll have to see whether short interest drops close to 11 million when mid-May figures are reported in a week by the exchanges.

As shown in the chart below, short activity in MHR took off in mid-January when shares borrowed spiked from 5 million shares to 15 million shares from January 18 to January 25.  Short interest activity continued to increase over the next couple months.  The cost-to-borrow has also declined right along with shares borrowed, indicating that there is reduced demand to borrow and sell short. 

(If hypothetically the cost-to-borrow had remained high and shares borrowed declined, this would have indicated that lenders were recalling their shares, putting pressure on short sellers to find shares elsewhere.  The conclusion in this hypothetical case would be that short sellers continue to believe that the shares are overvalued...AND long investors now believe the same thing and are recalling shares to sell them and get out of the stock altogether.)

As this is not the case with MHR, it seems that those short sellers who covered 7 million shares are reconsidering their short position and covering because they do not think the shares of MHR are overvalued.

Just as the securities lending market provides signals about stocks that short sellers are borrowing in order to sell short, it also provides information on stocks that short sellers are buying back in the market and returning to lenders to cover their short positions.

As shown in the chart below, the number of shares of Conn's borrowed in the securities lending market decreased from 6.5 million to 5 million in April 2011.  With average trading volume of 200,000 per day, purchasing 1.5 million shares over the course of a month had a noticeable effect on Conn's share price.

As a confirmation of what we were seeing in the securities lending market, short interest in Conn's declined from 6.2 million at the start of April to 5.2 million at the end of April.

Another thing to notice in the chart below is that the cost-to-borrow decreased right along with the decline in number of shares borrowed.  This is an indication that the decline in shares borrowed is due to short sellers returning shares of their own accord, versus lenders demanding those shares be returned.  If the latter were the case, the cost-to-borrow would increase as prime brokers would scramble to find substitute shares to continue to cover their short seller clients' positions.  Nevertheless, this latter case could still lead to a short squeeze if brokers were not able to find additional shares and short sellers were forced to buy in the market and break their trade.