Handling stocks on Wall Street — or from your computer at home — is a risky business. Investors are in it to win it, but that is not always the outcome received from a particular stock.
From novices to experienced day traders, investors search through a vast number of investment strategies and share prices to choose from. Each strategy is carefully selected based on their financial goals.
One strategy is known as a short sale. That’s right, selling an investment for less can make your portfolio grow, but the timing needs to be correct.
Read on to learn more about short interest stocks and how investors use short interest positions.
What Does “Short” Mean in the Stock Market?
What a versatile word “short” is. It can refer to the distance between one place and another or the measurement of a person’s height.
In the stock market, you may hear the terms short and long used differently than what you are used to.
When investors are in a “short” position, they are selling stock they do not own or have borrowed.
Investors are likely to support a “short” position when they have that sixth sense of the price of a stock dropping. This way, if the value does decrease, they can swoop in and buy it back at the lower value, anticipating selling it again when the price increases once more.
To obtain the shares of a company for a short sale, investors contact their brokers or dealers. This investment strategy does not always sit well in terms of investor sentiment. Even experienced investors may find the process challenging due to its volatility.
A “long” position is the opposite, meaning that the investor owns the stock or security.
How To Short a Stock
The fundamentals of shorting a stock are:
- Open a margin account. It’s time to prepare the chessboard and play. Margin accounts are simply margin loans. Investors can borrow shares from brokers or dealers, but they also need to pay interest on outstanding debt.
- Abide by the Federal Reserve requirements and get ready to make a trade. The margin account must have a minimum of 50% of the short position’s value available to use as collateral.
- Hold the short position. For how long? That is up to the investor. It could be held for a few hours or a few weeks.
- Close the short position once the stock price falls. Buy the shares at the lower price, then the shares that were borrowed are paid back to the dealer or broker.
- Assess the strategy for profitability, including interest and fees paid during holding.
What Is Short Interest?
Day traders reap the most benefits out of different levels of short interest. It serves as an excellent technical indicator of how a portfolio is performing.
Short interest incurs at the time the investor sells the shares before it is repurchased at a lesser value. It is expressed as either a percentage or an absolute number.
To calculate short interest, take the total number of shares that are sold short divided by the total number of outstanding shares (or share float).
Short Interest in Stocks
Get your short positions and say “cheese!”
That snapshot is your short interest. It’s the total number of short positions an investor has open and on the brokerage firm books at a given time.
Brokerage firms are required by the U.S. exchange rules and FINRA to report short interest twice a month to FINRA. This is reported for all stocks, including those traded over-the-counter (OTC) and those that are listed or exchanged on the stock market exchange.
How To Read Short Interest (What Does It Tell Investors)?
Short Interest is available for investors trading on the exchange in a rolling 12-month view. For example, the New York Stock Exchange (NYSE) and NASDAQ publish short interest and other ratios to help investors make decisions.
Take a look at the short interest of a stock month over month. How does it trend? For example, the short interest at Apple (AAPL) as of 02/28/2022 was 110,322,490 versus 02/15/2022 at 108,944,701.
Bullish Versus Bearish
For investors, short interest in stock foretells the market forecast. Is the tone of the market bearish (decreasing value/negative) or bullish (increasing value/positive)?
A bearish market occurs when there is an increase of short interest. A bearish investor doesn’t want to lose out on any wealth, worried that the value of a stock will decrease. They get the name bearish from how a bear thrashes downwards with its paws.
A decrease causes a bullish sentiment. Bullish investors do not want to miss out on the action. They carry the assumption that the price is ready to rise. They get the name bullish from the way a bull pushes its horns upwards to strike.
Watch for the warning signs. Quick, drastic changes in short interest communicate to investors whether the stock is in a more bullish or bearish position.
The Short Interest Ratio
The formula for the Short Interest Ratio is as follows:
Short Interest Ratio (SIR) = Short Interest (SI) / Average Daily Trading Volume (ADTV)
Here are a few scenarios:
- If the ADTV is trending high, the SIR will be low.
- If the ADTV is trending low, the SIR will be high.
- If the SI is trending high, the SIR will be high.
- IF the SI is trending low, the SIR will be low.
Often, the short-interest ratio is used instead of the days to cover ratio.
The Days To Cover Ratio
The prime difference between the SIR and Days To Cover ratios is the numerator.
The Days To Cover Ratio is calculated as follows:
Days To Cover = Number of Shares Sold Short / Average Daily Trading Volume
This formula measures the estimated number of days it takes for short positions held in a company to be covered.
To interpret the formula, consider the following:
- The greater number of days to cover, the longer time it takes to undo short positions
- The lesser number of days to cover, the lesser time it takes to undo short positions
What Role Does Short Squeeze Play With Short Interest?
Imagine driving around a parking lot for what feels like a countless number of hours, even though it’s only been a few minutes. You finally find an open spot. Determined to park, you start pulling in — only to find your vehicle doesn’t fit.
That’s the stock market for you. It is not always as predictable as investors might say. There are plenty of times it doesn’t squeeze into an increase or decrease prediction, performing the exact opposite behavior.
Investors borrow shares from brokers and get ready to re-purchase due to falling prices; then, their value skyrockets instead. Now a decision needs to be made.
Does the investor decide to hold? This would result in additional interest payments on the shares and a lot of faith that the prices will decrease again as intended. Or, do they sell (exit the position) and take the loss of returning the shares at a higher value?
Indicators of a Short Squeeze
Are there warning signs that a short squeeze is about to brew?
Here are a few things that investors can look for:
- The heat is on. Are the numbers of stock shares purchased rising, creating buying pressure?
- What is the short interest percentage? Anything 20% or greater is an indicator that a short squeeze may be around the corner because there are many shares held by short-sellers.
- What is the SIR or Days To Cover? Anything 10 or above may be questionable.
Reducing the Risk of a Short Squeeze
Investors can take a few steps to alleviate some of the risks of a short squeeze taking place. They can:
- Use stop-loss and buy-limits. Providing a buy or sell limit gives you the control, selling or buying at the price you set.
- Hedge a short-term position with a long-term one. Call options create a contract between the buyer and seller to buy or sell at a specified price. The options include a pre-determined expiration date.
Small-cap stocks are more prone to a short squeeze, but that doesn’t mean large-cap stocks are immune.
The Bottom Line
Although it tends to be overlooked by investors, don’t use short interest as an exclusive indicator of a stock's position on the market when making investment decisions. Combine it with other metrics for a well-balanced choice.
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