Definition, Examples, and Uses of Short Interests

This article will help you understand almost everything you need to know about short interests. It will explain to you what short interests are, the significance of short interests, and some examples of how to use them. It will also explain to you the major differences between short interests and the put/call ratio. I believe that by the time you are done reading, you will have adequate information you need about short interests, and you will be able to apply it in real life. Let us now start off by understanding the meaning of Short Interests.

What are Short Interests?

Short interest refers to the number of shares that shareholders/investors are currently short on a specific stock but which are yet to be repurchased or covered. Short interests are often indicated using a percentage or a ratio that indicates the number of outstanding shares. Investors usually pay attention to short interests to help them determine the prevailing market sentiments regarding a specific stock.

For instance, assuming that investors shorted 20 million shares of a company A and then covered 5 million shares by repurchasing the stocks, the prevailing short interest would be 15 million shares (20 million – 5 million).

Short Interest Ratio

The short interest ratio refers to the total number of days (depending on the prevailing average stock trading volume) that all short sellers will take to cover all their short positions.

For example, assuming a specific stock has 15 million shares of short interest and an average trading volume of 5 million shares, the short interest ratio would be arrived at by dividing 15 million by 5 million to yield 3. As such, three days becomes the short interest ratio.

High short interests are perfect indicators that the investors are highly pessimistic. The consequence of highly pessimistic investors is that there might be a sharp rise in stock prices. Vast changes in the short interest also tell us one thing; that it is possible that the investors are becoming more bearish or bullish on a stock.

What does Short Interests Tell us?

Short interests are significant because they provide valuable insights into the potential directions in which the stock prices will move. Additionally, they provide insights over how bearish or bullish the investors have become regarding a specific stock.

Stock exchanges are primarily tasked with measuring and reporting on short interests. They will give an insightful report at the end of every month, thereby providing investors with a tool to use as a benchmark or a threshold for short-selling. Apart from publishing these reports at the end of the month, the Nasdaq exchange also publishes such reports in the middle of every month, making it the favorite stock exchange.

If a stock increases or decreases extensively from the previous month, then it might indicate the possibility of market sentiment. For instance, assuming that the short interest for a company A stock was 10% in May but rose to 20% in June, such a rise should be seen as a warning sign about a negative sentiment for company A.  it means that the number of investors who are expecting the stock price to decrease has increased two times, giving investors a reason to dig deeper with their stock analysis.

Stocks that tend to depict the extreme short interest character are usually prone to short squeezes. For clarity, a short squeeze refers to a large stock price spike (but in the short term) that occurs when a sizeable number of short-sellers are forced to cover or exit their positions by purchasing shares of stock.

Short interest analysis can be applied to individual stocks or stocks as a whole. To determine the whole stock market, an investor may approach it from the days-to-cover perspective by taking the total short interest and dividing it by the average daily NYSE trading volume.

The procedure of Shorting a Stock

Recall that short interest refers to the total number of shares of a specific stock sold short but which are yet to be repurchased or recovered by the investors. It means that, as more and more investors short a stock, the short interest increases. The following is the procedure followed when shorting a stock.

1.     Borrowing the Stock

The first step in shorting a stock is investors contacting their brokers, who then locate other investors owning stock to borrow the stock but with the assurance of returning the stock at a future date. The broker acts as the middleman but can decide to loan the investor the stock from its equity. As a reward for loaning out the stock to the trader, the broker will receive a predetermined fee from the trader.

2.     Selling the Stock

Upon receiving the stock from the broker, the trader will immediately sell out the stock in the open market.

3.     Repurchasing the Stock

As the stock value drops, the trader now repurchases the stock at a lower rate. The process of purchasing a stock at a lower rate is referred to as short covering.

4.     Returning the Stock

The trader now returns the borrowed stock to the broker and makes a profit. The profit here is the difference between the price at which the trader paid to repurchase the stock and the price at which the trader is selling the stock. However, the trader is also bound to incur a loss if the stock prices continue to rise even after the trader sells short.

Please note that in this process, the short interests are created between step two and step three.

What are Some of the Examples of How to Use Short Interests?

The concept of short interests can be applied in various ways. For instance, it can be used by traders who are interested in short squeezes. If you are such a trader, you should pay close attention to the stocks that depict a significant increase in the short interests or the ones that are charactered by a high number of days-to-cover.

Short interests are also vital because they are used to assess the short sentiments around a company's stock. The whole concept of short interests provides a valuable insight into how investors feel about a specific stock. Most stocks usually have an average amount of short interests that investors hold.

Whenever the short interest of a specific company increases, it is often a warning sign that the stock sentiment is bearish. On the flip side, when the short interest decreases, it is a perfect indicator of bullish stock sentiment.

However, as an investor, you should note that although the idea of short interest is fascinating and essential, you must not rely solely on it when making stock investment decisions.

What is the Main Difference Between Short Interests and the Put/Call Ratio?

The Put/call ratio, just like the short interest, is also an indicator of market sentiment. However, whereas the short interest technique pays much attention to the number of short shares that are outstanding at a given time, the put/call ratio mainly focuses on the options market for data to use in making a decision.

Put options refer to bearish bets, while call options are bullish bets. The deviations in the put/call ratio are thus essential tools that can gauge investors' position regarding their future price expectations.

What are some of the Limitations of Using Short Interest?

The short interest technique is a great tool, but you should not solely depend on it to make investment decisions as they may lead you into making wrong decisions. Short interests usually have some limitations, which make it a not-so-ideal decision tool.

For instance, a change in short interest does not always mean that an extreme price change will follow. A stock can easily maintain an extreme reading without impacting a major price change. Additionally, the short interest data is published once at the end of every month, with the exception of Nasdaq, which publishes it twice (mid and end month). This means that the data that the traders use is usually slightly outdated and cannot be entirely relied upon in making decisions. In short, the prevailing circumstances may slightly deviate from what the report says.

The Bottom Line

The concept of short interest is essential to stock traders. It can be used to make informed decisions. However, it is not wise to rely upon short interests alone as the basis of making investment decisions. This article has explained the whole concept of short interest, the procedure of shorting a stock and the importance of short interest. I hope you will find this information valuable and helpful.