Profits can be made when the stock market is falling as well as rising. Instead of buying shares, investors open their trade by selling stock shares. Stock exchanges track the number of shares individual investors and financial institutions have sold short and report those figures twice a week. Understanding the relationship between short interest and the free float can help you decide if it is time to sell short.
Whereas free float represents the number of shares a company has offered for public trading, short interest is a measure of how many shares have been sold by investors seeking to short them and not yet paid back.
Defining Free Float
Also known as public float or float, the free float is the number of shares a company makes available for public trading. The float does not include the shares held by company insiders and private individuals.
The size of a company’s free float can tell you something about the stock’s volatility. Stocks with a small float are more volatile since there are fewer shares available to trade. Just as low liquidity can significantly increase price volatility, so can a shallow supply of available shares to trade. Large hedge firms and institutional investors usually buy stocks with a large float so as not to impact a company’s share price.
Exploring Short Interest
When investors want to sell stock short, they borrow the shares from their brokers. The number of shares that have been sold but not bought back is known as the short interest. Investors hope the stock price will fall so they can buy back the shares at a lower price for a profit.
Companies with deteriorating fundamentals or financial weaknesses are potentially good shorting candidates. The higher the short interest number, the more market pessimism there is about the stock.
Identifying the Short Interest Ratio
Short interest ratio is the number of days it would take for the short sellers to buy back the stock they sold short. Short interest is computed by taking the total number of shares held short and dividing it by the float.
For example, if XYZ stock has 50,000 share held short and a float of 1 million shares, divide 50,000 by 1 million to get the short interest ratio of 5 percent. The higher the short interest ratio, the more investors expect the stock price to fall.
Short Interest Vs. Float
Since the float remains fixed, short selling fluctuations can be measured and compared to previous time periods. A high short interest ratio invites further investigation to determine why the stock is being intensely shorted.
Be wary of short selling a stock just because it has a high short ratio. Should the stock price move up, short sellers will scramble to buy enough shares to cover their short positions. Their trading losses will continue to mount until their short positions are closed.
Video of the Day
- Hemera Technologies/AbleStock.com/Getty Images