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.
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.)
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.
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.
The higher the short interest and the higher the short ratio, the dicier 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."
Video of the Day
- "The Wall Street Journal Guide to Understanding Money and Investing"; Kenneth Morris and Virginia Morris
- The Street: How Short Selling Works
- Dave Manuel: What Is Meant by 'Short Interest' and 'Short Ratio'?
- Spencer Platt/Getty Images News/Getty Images