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

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 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 

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 

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 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.