Promise Center


The Short Ratio, Short Selling, and Short Squeezes Explained

Using hindsight bias it’s easy to explain, but there are many stocks that have a high short interest without ever causing a short-squeeze. But because squeezes are rare and random, we decided our resources were better spent elsewhere. A short squeeze happens when those that are short need to buy back the shares in the market.

  1. It’s computed by taking the total number of shares sold short in a company and dividing it by the average daily trading volume of the stock.
  2. A short squeeze occurs when a high number of short sellers attempt to cut their losses and exit their short positions by purchasing their borrowed shares due to panic about potential losses.
  3. The NYSE short-interest ratio is calculated by taking the number of shares sold short on the entire NYSE and dividing it by the daily volume on the NYSE for the previous 30 days.
  4. The stock market has risen about 10% annually for over a century, and it goes without saying that it’s hard to make money on the short side by betting against this tailwind.
  5. When the short interest ratio is high, the number of shares that will be repurchased in the open market after short selling is high.

A high Short Interest Ratio can sometimes precede a short squeeze, a rapid price increase driven by short sellers rushing to cover their positions. The result represents the number of trading days it would take for all short positions to be covered, assuming the volume remains consistent. The rationale is that if everyone sells, the stock is already at its low and can only move up. 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. A large increase or decrease in a stock’s short interest from the previous month can be a very telling indicator of investor sentiment.

Short selling is a high-risk strategy to be used only by traders with a strong conviction on their bearish ideas. When a company’s short interest is high (above 20%), most of a company’s investors are hoping the shares are heading down in price. The empirical evidence suggests that stocks with high short interest perform worse than stocks that have little short interest. Thus, short squeezes like happened in Gamestop are not the norm – they are outliers.

If the stock goes lower, the short seller buys back the shares at a lower price, returning those shares back to the broker. A low short interest ratio of between 0 to 4 suggests that not many traders think the share price will drop significantly. However, the opposite happened—the forex market hours price just bounced back up after reaching its previous low point, which is typical for stable stocks. As the price dropped again afterward and reached the same price, short interest spiked again, and the stock bounced back up again, decimating short sellers’ positions.

What Is the Short Interest Ratio?

Additionally, FINRA regulates broker-dealers and ensures reporting compliance. FINRA, a government non-profit organization, was established to protect investors and ensure market integrity. Understanding the short ratio helps in assessing the potential risk and volatility of a particular stock. The metric’s calculation also includes trading volume in the denominator, which results in a higher short interest value to thinly traded stocks. Short interest can provide insight into the potential direction of an individual stock, as well as how bullish or bearish investors are about the market overall. Stock exchanges measure and report on short interest and issue reports each month, providing investors a tool to use as a short-selling benchmark.

Short selling is difficult and we should be happy investors are willing to compete in this challenging business. A high short interest might signal investors are pretty pessimistic about the prospects for the company. Likewise, sudden changes might be positive and negative, depending on the circumstances.

Is there any other context you can provide?

Because of the margin requirements, shorting a stock is an inherently short-term strategy. The longer that a short position is kept open, the more interest you’ll have to pay to your broker to keep your trade on margin. Like mentioned, the short ratio can be a great tool for identifying potential future short squeezes.

Thus, the short ratio may not always capture market changes in the interim period. In the previous section, you might have noticed that we have not stated definitive interpretations for the short ratio. The short ratio is not a perfect indicator on its own but just a starting point to understand a stock market performance. If you’re interested in finding out if a stock is being shorted, you can look at the company’s financial reports. A significant boost in short interest or a sharp drop from the previous month’s figure might be an indication of sentiment.

Importance of Short Interest

Whether you agree with the overall sentiment or not, it is a data point worth adding to your overall analysis of a stock. Although it can be a telling sentiment indicator, an investment decision should not be based entirely on a stock’s short interest. That said, investors often overlook this ratio and its usefulness despite its widespread availability. Unlike the fundamentals of a company, the short interest requires little or no calculations.

If a stock has a high short interest, short positions may be forced to liquidate and cover their position by purchasing the stock. If a short squeeze occurs and enough short sellers buy back the stock, the price could go even higher. The New York Stock Exchange (NYSE) short interest ratio is another great metric that can be used to determine the sentiment of the overall market. Let’s assume you see an opportunity in the stock of a struggling company and believe the price will fall.

If this were to happen, 200 shares would have been sold short even though only 100 shares existed in the float. Though a rare occurrence, it is possible that in extreme instances, the number of shares shorted can exceed 100%. However, simply looking at a stock’s short interest is a great way to quickly determine if a company is being targeted by bearish investors. In this case, short sellers have to limit the losses by buying the shares quickly at a price that’s available—and when they start buying en masse, they might pump the stock. Simply, a high short interest ratio means that the demand for buying a stock is very high—consequently, the price is likely to go up. Needless to say, a stock’s short interest can be much greater than what public data seems to indicate, which can amplify the effect that a stock’s short interest will have on its future price.

If short interest is one million shares, and its average daily trading volume is 100,000 shares, it will take at least 10 days on average for the shorts to be able to cover their positions. It involves borrowing shares from a broker and selling them with the hope that the price will fall. If the price falls, you can purchase the shares and give them back to the broker. Because it’s a speculative tactic, it shouldn’t be used by inexperienced traders. Even those with a lot of investment and trading experience should do their due diligence before executing this type of strategy.

Examples of Using Short Interest 📝

This continues to build on itself and can create huge stock gains in a very short time period. Thus, short interest shouldn’t be relied on as the only signal when trading. Underlying fundamentals and technical indicators should supplement signals from the short interest to see if there’s a short or long opportunity. Alice Guy is a Suffolk-based finance writer, a busy mum of 4 older kids and a self-confessed personal finance geek. She trained as a chartered accountant with KPMG London before working for Tesco Plc as a business analyst.

Why is Short Interest Important? 👨‍🏫

The ratio tells an investor if the number of shares short is high or low versus the stock’s average trading volume. Another measure is “short interest as a percentage of float,” which reflects the number of short-sold shares in proportion to the total number of shares available for trading in the public markets. Most stocks have a small amount of short interest, usually in the single digits.

The Financial Industry Regulatory Authority (FINRA) requires firms to report short interest positions in all customer and proprietary accounts in all equity securities twice a month. Now that we’ve explained what is considered a high short interest ratio, let’s consider how to trade using this information. A healthy short-interest ratio, indicating that the stock hasn’t been shorted heavily, usually falls between 1 and 4.

Leave a Comment

Your email address will not be published. Required fields are marked *