In this week's screen, the staff at Kapitall.com looks at a market sentiment indicator called the short ratio to find new stock picks.
The short ratio is the number of shares sold short (short interest or bets that the stock will go lower in price) divided by the average daily volume. This is also sometimes referred to as the "days to cover" ratio because it tells approximately how many days it will take short-sellers to cover their positions if good news sends the price higher.
The higher the ratio, the longer it would take to buy back the 'sold' (borrowed) shares. And in theory, the more short positions there are to cover, the stronger the short covering rally would be.
How to Use It
Many people who use this indicator like to look for the number of "days to cover" to be higher than 8-10 days. It's generally believed that a short ratio of that size could prove difficult to cover and therefore trigger a strong rally on any hint of an upswing. (My personal preference is to take that into consideration, but also compare it to the industry's average ratio and the stock's own historical ratio.)
And while I wouldn't recommend using just the short ratio as the 'be all to end all' of screening items, I do think it can be a great tool for helping define great opportunities.
Short Ratio and Consolidation
Sometimes when I'm looking for stocks that have been in a lengthy consolidation, I'll look for those stocks with high short ratios. Why? Because consolidation ranges are basically areas of market indecision. Bets are being made by both bullish and bearish investors. So finding stocks that are going back and forth near their price highs with a growing short ratio shows that ever-increasing bets are being made on prices going lower.
However, if the stock breaks out to the upside, properly positioned bulls will more than likely add to their winnings, undecided traders will now be convinced to get long, and shorts will have to scramble to cover their bearish bets. This can be an explosive situation.
Short Ratio and Bottom Picking
This can be used quite effectively for bottom fishing too.
When a stock is getting battered and pundits are wrangling over whether it's the bottom or not, you should pay close attention to the short ratio. Of course, there has to be a reason for a stock to move higher. So seeing an improving fundamental outlook is important.
But when lopsided market sentiment seems to be at its worst (reflected in investors' buying and selling) the short ratio can be just the thing to uncover extremes.
For example: for beaten-down stocks, you can search for companies near their 52-week lows with increasing short ratios. Or better yet, look for short ratios above their average values or even ones that are at (or near) their historical highs.
NEXT PAGE: 5 Stocks Fit the Criteria