What Is the Long-Short Ratio?

The long-short ratio represents the amount of a security that is currently available for short sale compared to the amount that is actually sold short. The long-short ratio can be used as an indicator for a specific security, but can also be used to show the value of short sales taking place for a basket of securities or for the market as a whole.

This ratio is impacted by the demand for borrowed securities required for shorting, and by the supply of securities available to be loaned out for short sale. It can be used as a market sentiment indicator. A large percentage of participants shorting the market indicates bearish sentiment and can be used to gauge short interest in a security.

Key Takeaways

  • The long-short ratio compares the amount of a security that is available to potentially be sold short with the amount that actually has been shorted.
  • Short sales involve selling borrowed securities that are not directly owned, in hope of buying them back later at a lower price.
  • The more shorts there are in relation to available supply of loaned securities, the greater the bearish sentiment it may indicate.

Understanding Long-Short Ratio

A short sale is a transaction in which the seller does not actually own the stock that is being sold but borrows it from the broker-dealer through which he or she is placing the sell order. The seller then has the obligation to buy back the stock at some point in the future. Short sales are margin transactions, and their equity reserve requirements are more stringent than for purchases.

The long-short ratio represents the amount of a security available for short selling versus the amount actually borrowed and sold. The long-short ratio is considered a barometer of investor expectations, with a high long-short ratio indicating positive investor expectations. For example, a long-short ratio that has increased in recent months indicates that more long positions are being held relative to short positions. This could be because investors are uncertain how new short sale regulations will affect the market, or that volatility is making short sales more risky investments.

As the ratio reaches its limit, a stock may become hard to borrow, meaning that it is very expensive or in some cases impossible to sell short any more of that security since all available supply for lending has been used up. Regulation SHO, which was implemented Jan. 3, 2005, has a "locate" condition that requires brokers to have a reasonable belief that the equity to be shorted can be borrowed and delivered to the short seller.

Hedge funds typically make up a large portion of the short sale market. This is related to their long/short strategies. If hedge funds reduce their short sale positions, as happened during the 2007-2008 financial crisis, the long-short ratio will increase. Regulators consider short selling a factor that led to the financial crisis, and have increased scrutiny on the industry.

Special Considerations

The ratio can be affected not only by the demand of investors interested in borrowing securities for short sale, but also by the supply of securities available for short sale. Pension funds, for example, typically hold securities long-term. If they are unwilling to lend, then high demand from hedge funds will not matter.