Short Interest: What It Is, Formula and Significance In Trading

Shorting a stock is a high-risk maneuver that can result in substantial losses if left to inexperienced investors. But shorting can also be very profitable and a great way to make money on the stock market. When done correctly, it can provide investors with an important tool for hedging against downside risk.

So, what is short interest? In a nutshell, this is the percentage of shares sold short that have not yet been closed out. In this comprehensive guide, we'll cover everything you need to know about shorting a stock, including the risks and rewards, as well as some essential strategies for successfully shorting stocks.

Shorting a Stock

In simple terms, shorting a stock involves borrowing and then selling shares that you do not own in the hopes that they will decrease in value. Those shares can then be repurchased at a lower cost, allowing the investor to retain the cash proceeds. 

For example, let’s say you’re convinced that Company X is overvalued at its current share price of $100. You can short the stock by borrowing 100 shares and then selling them at $100 each.

If your forecasts are accurate and the value of the stock drops to say, $50 per share, you can cover your short position by buying back the 100 shares at $50 each and making a profit of $500.

Before delving deeper into the meainng of short interest, it’s important to point out the two key risks associated with shorting. For starters there is the risk of losing money if the stock price starts rising instead of falling. Also, this strategy has limited profit potential, but there is no limit on the losses that an investor can suffer.

What Is Short Interest?

Short interest is the numerical representation of the shares of a particular stock that have been sold short but not yet bought back. It’s calculated by dividing the number of shares shorted by the float — the total number of shares available for trading. It is used to indicate market sentiment and can be found on most financial websites. 

The Financial Industry Regulatory Authority requires companies to report short interest positions twice per month, which means the data is typically delayed by eight trading days. The data is easy to track, and even newcomers can do it using some of the beginner-friendly online brokerage platforms.

Importance of Short Interest

Short interest, by definition, serves as a sentiment indicator. A spike in the interest is an indication of more bearish investor sentiment, and a drop signals skepticism about a particular stock. So if there is a sudden increase in short interest, it may be a sign that the stock price is about to drop. 

When short interest hits low levels, it’s an indication that the price is making an upward move. This is often caused by investor buying, which includes short sellers trying to cover their positions to minimize losses.

In order to show positive sentiment, the company’s short interest should be less than 10%, according to the market research.

Short Interest Formula 

Let’s circle back to a point we touched on earlier: how is short interest calculated? You’ll get the exact figures by taking the total number of shares sold short and dividing it by the company's float (the total number of shares available for trading). It's worth noting that the other name for short interest is short float percentage.

Short Interest = number of shares sold short / number of tradable shares 

For example, if Company X has 50 million shares outstanding and 500,000 shares sold short, its short interest would be calculated as follows:

500,000 / 50,000,000 = 0.01% of float outstanding

If calculations aren’t your cup of tea, you can lean on one of the many online stock brokers to help you out with the math and offer other guidance and expertise. 

Short Interest Ratio 

The short interest ratio or SIR is one of the most important metrics that analysts look at when trying to understand market prospects. The ratio is often called "days to cover," which indicates how long it takes investors to close out an open position in the market. Here’s the formula for calculating it:

SIR = short interest / average daily trading volume

To illustrate it, let’s assume that investors have shorted 2,000 shares of Company X's stock. The company has a daily trading volume of 1,000. If we apply the formula for calculating SIR, we’ll get the following results:

X’s short interest ratio = 2,000 shorted shares / 1,000 average daily trading volume = 2 days to cover 

Now that we know how to calculate the short interest ratio, it’s worth noting that a high number is seen as unfavorable, while a low number is viewed as positive. This metric can be used to help predict price movements in the stock market: the more days until closing, the greater the chance of a short squeeze.

What Is Short Squeeze?

If you’re a beginner investor or you’re learning the ropes with AI-powered robo-advisor platforms, chances are you probably haven’t heard of a short squeeze. 

A short squeeze happens when a stock's price increases rapidly, causing short sellers to close their positions and buy assets to avoid further losses. Stocks with the highest short interest create buying pressure that can push the stock's price even higher, leading to more gains for investors who are long a stock.

Short squeezes often happen when a company announces positive news or beats earnings estimates, leading to a surge in the stock price. These events can trigger a cascade of buying as the short-sellers rush to cover their positions.

Limitations of Using Short Interest

Knowing all the terms related to short selling is one thing, but before you go and put your money where your mouth is, there are some things you should consider. First, short interest data isn't always accurate.

This metric can be skewed if a large number of shares are sold short on the last day of the reporting period, causing the short interest ratio to be artificially high. You probably already know what is considered a high short interest ratio and the disturbance it can cause on the market.

That’s why you might be happy to hear that more than 80% of the stock market is now automated, focusing on short-term movements and sell-offs rather than long-term outlooks. 

Additionally, the data only reflects what is happening in the stock market at a given point in time. It's possible that the sentiment towards a particular stock could change rapidly, leading to a short squeeze even if the short interest ratio is low. 

Bottom Line

We started out by asking: what is short interest in stocks? Our guide thoroughly explains the nature of this metric that can be used to gauge market sentiment and predict price movements. It represents the percentage of shares sold short and not yet covered.

The figures can help you make more informed investment decisions and know when to buy or sell a stock. However, it is vital to be aware of the limitations of this data before using it to make investment decisions. 

Finally, shorting a stock is risky and should only be done after careful consideration. If you're thinking about making this financial move, be sure to do your research, find out what a good short interest ratio is, and understand the risks involved.