Understanding Short Interest

03/27/2009 12:01 am EST

Focus: STRATEGIES

S. Wade Hansen

Co-Founder, Profiting with Forex (PFX) and Learning Markets

It Pays to Know Who Is Betting Against a Company

Every company has stock traders who believe its stock price is going to go up and stock traders who believe its stock price is going to go down. Typically, those stock traders who believe the stock price is going to go down simply put their money elsewhere by investing in other stocks. However, when stock traders believe so completely that a stock is going to go down, they actually sell the stock short.

As you will see in the "Understanding Short Interest" video below, knowing how many shares of a particular stock have been sold short is a valuable indicator and provides a glimpse into the investor psychology surrounding that stock. Of course, just looking at today's numbers doesn't tell you the whole story. You need to look at how those numbers are changing over time to get a complete picture. To do so, you can monitor three numbers:

1) Short interest
2) Days to cover
3) Short-interest ratio

What Is Short Interest?

Short interest is the number of shares that investors are currently short on a particular stock. For instance, if stock traders shorted 15 million shares of a company, and then covered 5 million shares by buying the stock back, the current short interest would be 10 million shares (15 million - 5 million = 10 million).

What Is Days to Cover?

Days to cover is the number of days-based on the average trading volume of the stock-that it would take all short sellers to cover their short positions. For instance, if a stock has a short interest of 20 million shares, and an average trading volume of 10 million shares, the days to cover would be two days (20 million / 10 million = 2 days).

What Is the Short-Interest Ratio?

The short-interest ratio is a comparison between the short interest in a stock and the total number of outstanding shares of that stock. For instance, if a company has a short interest of 15 million shares, and outstanding shares totaling 150 million, then the short-interest ratio is 10% (15 million / 150 million = 10%).

How to Use these Numbers

As you are monitoring a stock, you need to pay attention to the trends of the short interest, days to cover, and short-interest ratio numbers. If the numbers are trending higher, you know investor sentiment in the company is deteriorating and the stock price has an elevated risk of dropping. In this situation, you may want to consider selling your shares if you own stock in the company, or you may want to consider shorting the stock yourself, or buying a put on the stock if you don't already have a position in it.

Conversely, if the numbers are trending lower, you know investor sentiment in the company is improving and the stock price has an increased chance of rising. In this situation, you will most likely want to hang on to your shares if you own stock in the company, or you may want to consider buying the stock yourself, or buying a call on the stock if you don't already have a position in it.

Watch the video below for more information:

By S. Wade Hansen of PFXGlobal.com and LearningMarkets.com

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