Short interest gives you a sense of how pessimistic, or "bearish," the market is toward a particular stock's price. Investors who think the price of a stock is going to fall can bet money on their belief, and short interest tells you the extent to which they have done so.
Short interest is a representation of how many shares in a company have been sold as part of a short sale and have yet to be covered.
Understanding Short Selling
The "short" in short interest refers to short selling. If you expect the price of a particular stock to fall, you can profit off that falling price by executing a short sale. In a short sale, you borrow shares of the target stock from a broker and sell them at the current market price. Later, when the market price falls, you buy back an equal number of shares and return them to the broker.
Your profit is the difference between the price you received for the borrowed shares and the price you paid for the replacement shares. (The risk in short selling is that the price might actually rise, in which case you will lose money by paying more for the replacement shares than you got for the borrowed ones.)
Exploring Short Interest
Stock exchanges track how many shares of each stock have been sold short, but have not yet been replaced, or "covered." That number is referred to as the short interest in a stock, sometimes called "shares short." As a raw number, short interest doesn't mean much; you need to look at the context. Say the short interest in a stock is currently 1 million shares. If the company has only 4 million shares outstanding, then the short interest is high – 1-in-4 shares has been sold short. But if the company has 1 billion shares outstanding, then the short interest is very low – just 0.1 percent of shares are short.
Evaluating Short Ratios
A key piece of context for short interest is the stock's short interest ratio, or simply short ratio. Take the short interest and divide it by the average daily trading volume in the stock – the average number of shares of that stock bought and sold each day. For example, if a stock with a short interest of 1 million shares had an average daily volume of 400,000 shares, the short ratio would be 2.5. Short ratio is sometimes called "days to cover" because it tells you how many days of normal trading it would take to move enough shares to cover all short positions.
Defining the Short Squeeze
The higher the short interest and the higher the short ratio, the riskier it can get for short sellers of a stock. If a lot of "shorts" are trying to buy shares to cover their positions – either to lock in profits from falling prices or to cut their losses if the stock price has risen – their demand in and of itself can actually push the stock price up. As the price rises, more short sellers pile in to try to cover, raising the price further. This is called a "short squeeze."
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.