Short Interest Explained

08/24/2015 6:00 am EST

Focus: STRATEGIES

Alan Ellman

President, The Blue Collar Investor Corp.

Though it is currently not one of his screens, options expert Alan Ellman, of TheBlueCollarInvestor.com, highlights the topic of short interest. However, Alan also warns that even though it can be a telling indicator, an investment decision should not be based entirely on a stock’s short interest.

Covered call writers and put sellers are always looking for metrics to improve trading results. Recently, we have had several inquiries about adding short interest to the screening process. Over the years we have enhanced our Premium Member Stock and ETF reports based on feedback we have received from you, our members. For example, we added ex-dividend date information to our stock reports and implied volatility stats to our ETF reports. Obviously, we must limit the information provided such that the reports are user friendly and of the highest quality. That is what we strive for. Although short interest is not one of our BCI screens, some of our members have added this as an additional screen and I thought we might address it with you in a blog article.

Definition of Short Interest

The quantity of stock shares that investors have sold short (borrowed from the broker and then sold) but not yet covered or closed out. Short interest is a market sentiment indicator that tells whether investors think a stock’s price is likely to fall. Short interest can also be compared over time to examine changes in investor sentiment. Investors use short interest to make predictions about the direction a particular stock is headed and to measure the bullishness or bearishness of investors’ sentiment towards the market as a whole.

Short interest can be calculated as a percentage by dividing the number of shares sold short by the total number of outstanding shares. For example, 5% short interest means that 5% of the outstanding shares are held short. Short interest can also simply be expressed as the number of shares sold short but not yet covered or closed out. Firms are required to report their short positions as of settlement on the 15th of each month. A list is published eight business days later.

Short Interest Data as Published in the Wall Street Journal

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Related Definitions

  • Settlement Date:  The date specified for delivery of securities between securities firms. This date marks the official date for change of ownership and is used for accounting for long or short positions.
  • Short Interest:  The total number of shares of a security that have been sold short by customers and securities firms that have not been repurchased to settle outstanding short positions in the market.
  • Average Daily Share Volume:  The number of shares of stock traded each day, averaged over a one-year period.
  • Short-Interest Ratio: The number of shares sold short (short interest) divided by average daily volume. This is often called the days-to-cover ratio because it determines—based on the stock’s average trading volume—how many days it will take short sellers to cover their positions if positive news about the company lifts the price.
  • Days to Cover:  Calculated as the aggregate short interest for the month divided by the average daily share volume traded between short interest settlement dates. If days to cover is between 0 and 1, it is rounded up to 1 on Nasdaq.com.

A Review of Short Selling

Short selling is the opposite of buying stocks; it’s the selling of a security that the seller does not own, with the expectation that the price will fall. If, after a period of time, the stock price declines, you can close out the position by buying the stock on the open market at the lower price, return the stock to your dealer-broker and realize a gain. However, if the stock price rises, you lose money because you have to buy the stock back at a higher price. In addition, your broker-dealer can demand that the position be closed out at any time, regardless of the stock price. This demand typically occurs only if the dealer-broker feels that the creditworthiness of the borrower is too risky for the firm.

Short Interest Expressed as a Percentage Example

A stock with 1.5 million shares sold short and 10 million shares outstanding has a short interest of 15% (1.5 million/10 million = 15%).

Most stock exchanges track the short interest in each stock and issue reports at month’s end. These reports are great for traders because by showing what short sellers are doing, they allow investors to gauge overall market sentiment surrounding a particular stock.

NEXT PAGE: Is High Short Interest an Opportunity?

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Interpreting Short Interest

A large increase or decrease in a stock’s short interest from the previous month can be a significant indicator of investor sentiment. If BCI’s short interest increased by 10% in one month, this means that there was a 10% increase in the number of people who believe the stock price will decrease. Such a significant shift provides good reason for investors to research this matter in more detail. A great site for this is: www.finviz.com.

A high short interest stock should be approached with an open mind. Short sellers have been known to be wrong from time to time. In fact, many contrarian investors use short interest as a tool to determine the direction of the market. The rationale is that if everyone is selling, then the stock is already at its low and can only move up. These investors interpret a high short-interest ratio as a bullish signal because eventually there will be significant upward pressure on the stock’s price as short sellers cover their short positions (i.e. buy back the stocks they borrowed to return to the lender).

If BCI has a short interest of 150million shares, while the average daily volume of shares traded is 140 million. The calculation (150million/140million), determines that it would take 1.07 days for all of the short sellers to cover their positions. The higher the ratio, the longer it will take to buy back the borrowed shares, an important factor upon which traders or investors decide whether to take a short position. Typically, if the days to cover stretch past eight or more days, covering a short position could prove difficult.

The NYSE Short Interest Ratio

The New York Stock Exchange short-interest ratio is another metric that can be used to determine the sentiment of the overall market. The NYSE short-interest ratio is the same as short interest except it is calculated as monthly short interest on the entire exchange divided by the average daily volume of the NYSE for the last month. For example, suppose there are five billion shares sold short in May and the average daily volume on the NYSE for the same period is one billion shares per day. This gives us a NYSE short-interest ratio of five (five billion /one billion). This means that, on average, it will take five days to cover the entire short position on the NYSE. In theory a higher NYSE short interest ratio indicates a more bearish sentiment towards the exchange.

Short Squeeze

Some bullish investors see high short interest as an opportunity. This outlook is based on the short-interest theory. The rationale is, if you are short selling a stock and the stock keeps rising rather than falling, you’ll most likely want to get out before you lose a significant amount. A short squeeze occurs when short sellers are scrambling to replace their borrowed stock, thereby increasing demand and decreasing supply, forcing prices up. Short squeezes tend to occur more often in smaller-cap stocks, which have a very small float (supply), but large-caps are not immune to this situation.

Discussion

Although it can be a telling indicator, an investment decision should not be based entirely on a stock’s short interest. Unlike the fundamentals of a company, the short interest requires little or no calculations. Half a minute of time to look up short interest can help provide insight into what sentiment investors have toward a particular company or exchange. The BCI methodology does not incorporate this metric in its 1-month option-selling strategies but encourage those who value this metric to include it into the decision-making process.

By Alan Ellman of TheBlueCollarInvestor.com

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