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.1 These reports are great for traders because they allow people to gauge the 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 a 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 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.
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.
Let’s assume a stock 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 / 20,000,000), we find that it would take two 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.