5 Ways to Interpret Short Interest
When traders have bearish expectations for a stock, they might act on that forecast by selling it short. This means they borrow shares from their broker to sell, in hopes of buying those same shares back at a discount following the stock's expected decline. To learn more about short interest, how it's measured, and why it's such an invaluable sentiment indicator, read on.
Consider the short-to-float ratio. One popular way to determine how many traders are betting on a stock to decline is the short interest-to-float ratio. Short interest, as noted above, is the number of shares of a particular stock that bearish traders and investors have sold short. "Float," in this context, refers to the number of shares of a particular security that are available for public trading.
The short-to-float ratio, then, simply reflects the percentage of a stock's float that has been sold short by bears. There's no widely agreed upon benchmark for what constitutes a high short-to-float ratio, but anything at or above 10% can generally be considered significant.
Weigh the short interest ratio. A stock's short interest ratio (SIR) offers similar information to the short-to-float ratio, but the format is somewhat different. The SIR indicates how many trading days it would take to cover (i.e., buy back) all existing shorted shares at the stock's average daily trading volume. To arrive at this number, the total short interest on a given stock is divided by the equity's typical daily volume.
As with the short-to-float ratio, there's no distinct line in the sand -- but a SIR at or above 5.00 is generally considered noteworthy, since that figure suggests it would take a week for all of the existing short positions to be covered.
Review the recent trend. Short interest data is released on a semi-monthly basis by the New York and Nasdaq Stock Exchanges, with new data coming out around the second and fourth week of each month. Accordingly, each reporting period covers a roughly two-week span of time.
If the number of shorted shares declined during the latest two-week period, it suggests the short sellers have been buying back their bearish bets. Conversely, an increase in the number of shares sold short reveals that new pessimistic positions have been created.
Eye the stock's price action. Once you've determined whether short sellers are increasing or reducing their positions, you must place this activity in its proper framework by considering how the shares are behaving.
For example, there are two reasons short sellers might buy back their shares: one, to limit losses when a stock is rallying; and two, to lock in profits when a stock is dropping. On the other end of the spectrum, when shorts are ramping up their bearish exposure, it's worth noting whether they're predicting the continuation of an existing downtrend, or betting against a strongly performing stock.
Taking this one step further, you may also want to compare the security's historical short interest levels with its corresponding price action. How does the stock typically behave when short interest is rising (or falling)? Pay attention to any correlation between the two, since this pattern could very well play out again in the future.
Look at option activity. This final step is definitely worth taking, since option activity can offer some interesting clues about how traders are feeling. If you notice heavy call volume on a stock with high short interest levels, it may suggest that short sellers are hedging their bets. Since long calls allow you to lock in a maximum purchase price for the underlying security, they're a natural hedging vehicle for short stock positions (which otherwise would entail theoretically unlimited risk). So, if the equity is displaying some unexpected technical strength, shorts may opt to hedge with call options rather than hitting the exits altogether.
Meanwhile, a simultaneous increase in short interest and put volume has entirely different implications. Since puts are traditionally used to bet on a decline in the underlying stock, an increase in put activity that coincides with significant short selling might indicate that traders of all stripes are feeling very pessimistic toward the shares.
Putting It All Together: Using Short Interest as a Sentiment Indicator
Keeping informed about the level of short interest on individual equities can be a very effective method for measuring investor sentiment. Not only do these bearish bets offer clues as to how investors feel about the underlying stock's future prospects, but short interest also has the ability to spark (or perpetuate) big moves in the shares.
As discussed earlier, short interest is created when an investor sells stock that is borrowed from a broker. The investor hopes to then buy the stock back at a lower price in the future in order to replace the shares that were borrowed. In other words, a trader sells the stock short in order to profit from a decline in the share price -- ideally creating a "sell high, buy low" scenario. Therefore, a high level of short interest indicates pessimism, since many investors are banking on the shares to fall.
When short interest is high, and the underlying stock rises, it can force short sellers to cover their losing bets to curb losses. Since short sellers must buy shares to exit their positions, the very act of short covering translates into additional buying pressure for the stock.
When a security makes a sudden (or very significant) move higher -- perhaps due to an earnings surprise or other positive news -- it can trigger what's known as a short-squeeze rally. When a large number of short sellers are all spooked into exiting their trades at once, the resulting surge of buying activity can translate into dramatic upside for the shares over a relatively small period of time.
For this reason, we view high levels of short interest as a contrarian bullish indicator when a stock is trending higher. Essentially, all of those short sellers represent eventual future buyers as the positive price action continues.
However, short sellers can also play a role in exacerbating a stock's decline. As new short positions are created, it results in selling pressure for the shares. When a security is already faring poorly on the charts, a continued onslaught of short selling can serve as a persistent headwind, thereby accelerating an existing downtrend. In these types of situations, the shorts are said to be "in control" of the stock.
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