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Short selling allows a person to profit from a falling stock, which comes in handy as stock prices are constantly rising and falling. There are brokerage departments and firms whose sole purpose is to research deteriorating companies that are prime short-selling candidates. These firms pore over financial statements looking for weaknesses that the market may not have discounted yet or a company that is simply overvalued. One factor they look at is called short interest, which serves as a market-sentiment indicator. We'll look at short interest and how it can be used as an indicator for the near term performance of a stock.

The Art of Short Selling

Short selling is the opposite of buying stocks. It's the selling of a security that the seller does not own, done in the hope that the price will fall. If you feel a particular security's price, let's say the stock of a struggling company, will fall, then you can borrow the stock from your broker-dealer, sell it and get the proceeds from the sale. If, after a period of time, the stock price declines, you can close out the position by buying the stock on the open market at the lower price and returning the stock to your broker. Since you paid less for the stock you returned to the broker than you received selling the originally borrowed stock, you realize a gain.

The catch is that you lose money if the stock price rises. This is because you have to buy the stock back at the higher price. In addition, your broker-dealer can demand that the position be closed out at any time, regardless of the stock price. However, this demand typically occurs only if the dealer-broker feels that the creditworthiness of the borrower is too risky for the firm. (For a complete overview on short selling, see our How To Use Short Selling.)

Short Interest Shows Sentiment

Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. This can be expressed as a number or as a percentage.

When expressed as a percentage, short interest is the number of shorted shares divided by the number of shares outstanding. For example, a stock with 1.5 million shares sold short and 10 million shares outstanding has a short interest of 15% (1.5 million/10 million = 15%).

Most stock exchanges track the short interest in each stock and issue reports at month's end, although Nasdaq is among those reporting twice monthly. These reports are great for traders because they allow people to gauge overall market sentiment surrounding a particular stock by showing what short sellers are doing.

News Drives Changes in Short Interest

A large increase or decrease in a stock's short interest from the previous month can be a very telling indicator of investor sentiment. Let's say that Microsoft's short interest increased by 10% in one month. This means that there was a 10% increase in the number of people who believe the stock price will decrease. Such a significant shift provides good reason for investors to find out more. We would need to check the current research and any recent news reports to see what is happening with the company and why more investors are selling its stock.

A high short-interest stock should be approached with extreme caution but not necessarily avoided at all cost. Short sellers (like all investors) aren't perfect and have been known to be wrong. In fact, many contrarian investors use short interest as a tool to determine the direction of the market. The rationale is that if everyone is selling, then the stock is already at its low and can only move up. Thus, contrarians feel that a high short-interest ratio is bullish because eventually there will be significant upward pressure on the stock's price as short sellers cover their short positions. (Learn more in Can Perpetual Contrarians Profit As Traders?)

Understanding the Short-Interest Ratio

The short-interest ratio is the number of shares sold short (short interest) divided by average daily volume. This is often called the "days-to-cover ratio" because it determines, based on the stock's average trading volume, how many days it will take short sellers to cover their positions if positive news about the company lifts the price.

Again, let's assume Microsoft has a short interest of 40 million shares, while the average daily volume of shares traded is 20 million. Doing a quick and easy calculation (40,000,000/40,000,000), we find that it would take 2 days for all of the short sellers to cover their positions. The higher the ratio, the longer it will take to buy back the borrowed shares - an important factor upon which traders or investors decide whether to take a short position. Typically, if the days to cover stretch past eight or more days, covering a short position could prove difficult.

The NYSE Short Interest Ratio

The New York Stock Exchange short-interest ratio is another great metric that can be used to determine the sentiment of the overall market. The NYSE short-interest ratio is the same as short interest except it is calculated as monthly short interest on the entire exchange divided by the average daily volume of the NYSE for the last month.

For example, suppose there are five billion shares sold short in August and the average daily volume on the NYSE for the same period is one billion shares per day. This gives us a NYSE short-interest ratio of 5 (5 billion /1 billion). This means that, on average, it will take five days to cover the entire short position on the NYSE. In theory, a higher NYSE short interest ratio indicates a more bearish sentiment towards the exchange and much of the world economy as a whole by extension. (For related reading, see When To Short A Stock.)

Getting Caught in the Short Squeeze

Some bullish investors see high short interest as an opportunity. This outlook is based on the short interest theory. The rationale is, if you are short selling a stock and the stock keeps rising rather than falling, you'll most likely want to get out before you lose your shirt. A short squeeze occurs when short sellers are scrambling to replace their borrowed stock, thereby increasing demand, decreasing supply and forcing prices up. Short squeezes tend to occur more often in smaller cap stocks, which have a very small float (supply), but large caps are certainly not immune to this situation.

If a stock has a high short interest, short positions may be forced to liquidate and cover their position by purchasing the stock. If a short squeeze occurs and enough short sellers buy back the stock, the price could go even higher. Unfortunately, however, this is a very difficult phenomenon to predict. (Find out how this strategy is used in Short Squeeze The Last Drop Of Profit From Market Moves.)

The Bottom Line

Although it can be a telling sentiment indicator, an investment decision should not be based entirely on a stock's short interest. That said, investors often overlook this ratio and its usefulness despite its widespread availability. Unlike the fundamentals of a company, the short interest requires little or no calculations. Half a minute of time to look up short interest can help provide valuable insight into what sentiment investors have toward a particular company or exchange. Whether you agree with the overall sentiment or not, it is a data point worth adding to you overall analysis of a stock.

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