Should you avoid these heavily shorted stocks?

Woolworths Limited (ASX:WOW), Fortescue Metals Group Limited (ASX:FMG) and Santos Ltd (ASX:STO) are all being targeted by short sellers.

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As uncertainty creeps back into the Australian share market, short selling has been on the increase with Australia’s largest and most widely-held companies being targeted.

Short selling occurs when an investor believes a stock’s price will fall and hopes to profit from that weakness. Essentially, the trader borrows stock in a certain company and sells it on the market, hoping to then buy it back at a lower price. While this is a risky method of trading, it can provide huge returns if falls in a company’s share price eventuate.

As reported by the Fairfax press, Woolworths Limited (ASX: WOW), Fortescue Metals Group Limited (ASX: FMG) and Santos Ltd (ASX: STO) have been popular targets of short sellers since the beginning of the year, with investors becoming uncertain about their performance.

Woolworths has been under the pump over the last 12 months for several reasons. Investors are clearly concerned about the competitive threat posed by Costco and Aldi and the shares have also been weighed down by the company’s underperforming Masters Home Improvement chain. It has also posted weaker sales than rival Coles, which is owned by Wesfarmers Ltd (ASX: WES). The shares have fallen 3.3% since the beginning of 2015.

Meanwhile, falling commodity prices are inflicting a world of pain on Fortescue Metals Group and Santos. Oil and iron ore prices have both been smashed over the last year, putting both commodity producers under pressure.

In fact, Fairfax referred to UBS data which showed that Fortescue was the most shorted stock in the market.

As it stands, Fortescue and Santos are both risky bets for prospective investors. Both rely on strong commodity prices to drive earnings and further falls in their share prices could occur. On the other hand, investors could take advantage of the short activity surrounding Woolworths, which is deflating the company’s share price. Although the company’s immediate outlook remains uncertain, it is a good bet for the long term.

Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned. You can follow Ryan on Twitter @ASXvalueinvest.

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