What is the 'Short-Interest Theory'

A theory which holds that a security with a high degree of short interest may be poised to increase in price. The short-interest theory suggests that some heavily shorted stocks may be prime candidates for significant price appreciation in the near term, as short sellers buy the stock to cover their short positions. This buying pressure fosters a “short squeeze” and creates a price spike that may trigger more short covering. Since high short interest in a stock is generally a bearish indicator, the short-interest theory’s premise that such a stock will advance amounts to a contrarian bet. The theory focuses on stocks with high short interest, which is measured in terms of shares sold short either as a percentage of shares outstanding, or as a percentage of float.

BREAKING DOWN 'Short-Interest Theory'

For example, if Stock A has 50 million shares outstanding and 2.5 million of its shares have been sold short, it has a short interest of 5%. If stock B has 40 million shares outstanding, of which 10 million shares have been sold short, it has a short interest of 25%. The short-interest theory maintains that all other things being equal, stock B may have a higher probability of a near-term price increase than stock A.

Another measure used to identify stocks with potential for share appreciation is the short-interest ratio (SIR), which also considers average daily trading volume in the stock. Continuing with the earlier example, if Stock A has average daily trading volume of 500,000 shares, it would have an SIR of 5 (2.5 million / 500,000), and if 250,000 shares of B are traded daily, it would have an SIR of 40 (10 million / 250,000). The SIR means that it would take five days and 40 days, respectively, to buy back all the shares that have been sold short of A and B, respectively. This confirms the short interest theory that B is the better candidate for a price rise.

Investors should be careful not to rely too heavily on the short-interest theory to identify stocks in which to invest. Very often, a stock with an inordinately high degree of short interest may have deteriorating fundamentals and a highly leveraged balance sheet. While the stock may rise substantially if a positive development sparks a short squeeze, there is also a distinct risk that the short sellers may be right in their grim assessment that the stock may be headed much lower in the future.

RELATED TERMS
  1. Short Covering

    Buying back borrowed securities in order to close an open short ...
  2. Short Squeeze

    A situation in which a heavily shorted stock or commodity moves ...
  3. Days To Cover

    A measurement of a company's issued shares that are currently ...
  4. Short Interest Ratio

    A sentiment indicator that is derived by dividing the short interest ...
  5. Short Selling

    Short selling is the sale of a security that is not owned by ...
  6. Short Interest

    The quantity of stock shares that investors have sold short but ...
Related Articles
  1. Investing

    Short Interest: What It Tells Us

    A stock’s short interest is the total number of shares that investors have sold short but have yet to close.
  2. Trading

    Short Interest: What It Tells Us

    This figure can be a real eye-opener about the market sentiment surrounding a given stock.
  3. Trading

    The Short Squeeze Method

    The short squeezed strategy can be risky - but also very rewarding - for those who master it.
  4. Investing

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
  5. Financial Advisor

    The 5 Most Shorted NYSE Stocks (VALE, CHK)

    Understand what a short sale is and why people would want to initiate a short strategy. Learn about the top five most shorted stocks on the NYSE.
  6. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  7. Trading

    Difference Between Short Selling And Put Options

    Short selling and put options are used to speculate on a potential decline in a security or index or hedge downside risk in a portfolio or stock.
  8. Investing

    The Basics Of Short Selling

    Short sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
RELATED FAQS
  1. How is the short interest of a company related to a short squeeze of a company?

    Learn about the short interest and short squeeze, how to determine if a stock is a short squeeze candidate and how short ... Read Answer >>
  2. What is the difference between a short squeeze and short covering?

    Learn about short covering and short squeezes, the difference them and what causes short squeezes. Read Answer >>
  3. What percentage of a company's float can be shorted?

    The quick answer is that the amount of shares shorted can actually exceed 50% of the float in a company. The percentage of ... Read Answer >>
  4. How does days to cover a short position relate to a short squeeze?

    Learn about days to cover and how it relates to a short squeeze. Smart traders can use this metric to help them avoid getting ... Read Answer >>
  5. How long can a trader keep a short position?

    Learn whether there are any limitations on how long may an investor hold a short position, and explore the costs associated ... Read Answer >>
  6. When short selling, how long should you hold on to a short?

    Explore the reasons for short selling and the various factors that influence how long an investor may wish to maintain a ... Read Answer >>
Hot Definitions
  1. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  2. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  3. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  4. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  5. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  6. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
Trading Center