Short selling is the sale of shares borrowed from a broker. The objective is to buy these shares back later at a lower price, thus making a profit. Short interest refers to the number of shorted shares for a particular stock. A short squeeze occurs when short sellers have to cover their short positions during a price rally. The level of short interest affects the size of a short squeeze.
Short Interest Ratio
Short interest ratio is the ratio of short interest to float, expressed as a percentage. The float of a stock is the number of outstanding shares available for trading. The ratio can also be expressed as the number of days to cover, which is the total short position divided by the average daily trading volume. High short interest ratios typically indicate bearish market sentiment, while low ratios could indicate neutral or bullish sentiment. Stock exchanges track and report short interest positions, usually on a monthly basis. You can find short interest information on financial websites, such as the Market Data Center section of "The Wall Street Journal" website.
Short squeeze occurs when short sellers try to cover short positions, thus driving up demand. The trigger for a short squeeze is usually a sharp rally in the stock price as the result of unexpectedly positive news events. For example, short positions could increase for a company that has reported losses recently. However, if the company suddenly reports better-than-expected earnings or receives a takeover offer, renewed investor demand for the stock could result in a price rally. Short sellers would then have to cover their short positions to cut their losses, which would drive up prices.
The potential for a sizable short squeeze increases with the short interest ratio. This intuitively makes sense because a higher ratio means that a larger number of short sellers would have to cover their positions. Investors who buy into these short-squeeze rallies should remember that weak companies and industries do not turn around overnight, if ever. This means that these short-squeeze price rallies may not last long, and the stock price could succumb once again to selling pressure.
You could hedge against losses in a short position in a couple of ways. You could place a stop-buy order, which fills as a market order if the stock price increases past a stop price. This way you will limit your losses by automatically covering your short position at a predetermined price. You could also use call options to hedge a short position. Call options give you the right to buy the underlying shares at a set price, known as the strike price, before predetermined expiration dates. If the stock price rallies past the strike price, you could exercise your right to buy the shares and cover your short position at a minimal loss.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.