What Is Short-Interest Theory?

Short-interest theory states that high levels of short interest are a bullish indicator. Therefore, followers of this theory will seek to buy heavily-shorted stocks and profit from their anticipated rise in price.

This approach goes against the prevailing view of most investors, who see short selling as an indication that the shorted stock is likely to decline. Therefore, short-interest theory can be viewed as a contrarian approach to investing.

Key Takeaways

  • Short-interest theory is the view that heavily shorted stocks are more likely to rise in the future.
  • It is a contrarian approach because most investors view short interest as a bearish indicator.
  • The foundation of short-interest theory is the fact that short sellers are sometimes forced to aggressively buy shares in order to cover their positions.

Understanding Short-Interest Theory

Short-interest theory is based on the mechanics of short selling. When investors short a stock, they effectively borrow that stock from a broker and then immediately sell it for cash. Eventually, when the broker demands to be repaid, the investor must do so by buying the shares in the open market and returning those shares to the broker.

Short sellers make money if the price of the shares they shorted declines after they sold their shares. In that scenario, the short-seller can buy back the shares at a lower price and return them to the broker, pocketing the difference as profit.

But what happens if shares rise in price after the initial sale? If that happens, the investor needs to buy them back at a higher price, resulting in a loss. If lots of people have shorted a stock and they see that its price is gradually rising, they might panic and try to buy the stock in order to limit their risk that its price will rise even higher. This situation of panicked buying is known as a short squeeze.

Short-interest theory seeks to profit from these short-sellers’ predicament. Followers of the short-interest theory believe that heavily shorted stocks are more likely to rise because short sellers might be forced to buy stock in high volumes during a short squeeze. This type of buying is known as short covering.

Another approach that uses short interest to identify stocks with potential for share appreciation is the short-interest ratio (SIR). The SIR is the ratio of shares sold short to average daily trading volume (ADTV). For example, if XYZ has one million shares sold short and an ADTV of 500,000, then its SIR is two. This means that it would theoretically take at least two full trading days for the short sellers in XYZ to cover their short positions.

Investors can use the SIR to quickly tell how heavily shorted a company is. For followers of the short-interest theory, SIR can be used to determine which companies offer the most potential price appreciation.

Real World Example of Short-Interest Theory

If Stock A has 50 million shares outstanding and 2.5 million of its shares have been sold short, then its short interest is 5%. If Stock B has 40 million shares outstanding, of which 10 million have been sold short, then its short interest is 25%.

According to the short-interest theory, Stock B has a higher probability of increasing in price than Stock A, assuming the stocks are otherwise identical. This is because Stock B is more likely to be a target of short covering caused by a short squeeze.