Short interest can be a useful sentiment indicator, as it measures the level of investor pessimism toward a given stock. Specifically, short interest is created when an investor sells shares of a stock that he or she has borrowed from a broker, but does not own outright. A basic short-selling strategy is profitable when the price of the shorted stock declines, allowing the investor to buy the stock back at a lower price in order to replace the borrowed shares. Thus, the short seller hopes – and likely assumes – that the stock he or she has sold short will continue to drop.
Twice a month, brokerage firms are required to report the number of shares that have been shorted in their client accounts. This information is compiled for each security and then released to the public. By monitoring changes in a stock's short-interest figures, investors are able to gauge the public's level of pessimism toward the stock. Generally speaking, a high volume of short interest indicates that investors have a negative outlook for the company (although heavy short interest can also be created out of arbitrage situations, such as mergers and the release of convertible bonds). From a contrarian viewpoint, we see this pessimism as bullish for the stock if it is in an uptrend.
Why is heavy short interest a bullish indicator? Well, a substantial accumulation of short interest on a particular stock leaves the door open for a potential short-squeeze rally. This situation typically occurs when an equity suddenly moves sharply higher – perhaps as the result of a positive earnings surprise, or an analyst upgrade. A sharp increase in price results in a loss for the short sellers, forcing them to cover (or buy back) their bearish bets in order to minimize the damage. This rush to cover their shorted shares leads to further gains in the shares, and in turn draws more short sellers into covering their positions.
Yet, this kind of short-squeeze situation is not necessary for a bullish investor to reap the benefits of this bearish sentiment. Heavy short interest on a rising stock can help fuel the security’s rally as these shorted shares are slowly and steadily unwound in the form of buying pressure. On a strongly uptrending security, a healthy accumulation of short interest can be thought of as sideline cash should the stock's gains continue.
Can heavy short interest be used as a bearish indicator? Actually, it can. If a stock is in a sharp downtrend and is also faced with a heavy amount of short interest, we could see the stock suffer additional significant losses as the bears increase their short positions. In these scenarios, we consider the bears to be "in control" of the stock, as continued downward momentum gives the shorts very little motivation to exit their winning trades.
There are two key indicators that are used to measure the level of short interest: the short-interest ratio and short interest as a percentage of a stock’s total float. The short-interest ratio is determined by dividing the total number of shares sold short by a stock’s average daily trading volume during a one-month period. The short-interest ratio is a rough estimate of how many days it would take investors to buy back all of their shorted shares at the stock’s average daily trading volume. For our purposes, we typically view any reading above 5 as a sign of heavy pessimistic sentiment.
Meanwhile, the percentage of a stock’s total float (or the total number of shares of a company available for trading) that has been dedicated to short selling is another indication of how bearish investors might be. For our purposes, we typically view any readings above 10% as a sign of heavy pessimistic sentiment.