What is the 'Short-Interest Theory'

Short-interest theory is a theory that 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 an 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.

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