What Short Interest Tells Us About Market Sentiment

Short interest serves as a useful sentiment indicator, helping us to measure the level of investor pessimism surrounding a specific stock. Short interest occurs when an investor sells shares of a stock that he or she has borrowed from a broker and does not own. Investors implement a short-selling strategy in hopes that a stock’s price drops, so they can eventually buy the shares back at a lower price. Thus, we can assume that an investor who sells short is pessimistic about the stock.

Using Short Interest as a Bullish Indicator

A high volume of short interest tells us that investors are pessimistic about a stock, though occasionally it can be created out of arbitrage situations. But generally, heavy short interest can be viewed as a bullish indicator when a stock is in an uptrend. Specifically, heavy short interest opens the door for a potential short-squeeze rally, which forms when short sellers are forced to buy back (or cover) their bearish bets to limit losses amid sharp price increases. As short sellers hurry to cover their shorted shares, the shares collect more gains, triggering more short sellers to follow suit and cover their positions.

Using Short Interest as a Bearish Indicator

An elevated level of short interest can also be used as a bearish indicator. When paired with a sharp downtrend, heavy short interest could mean a stock will suffer even more as bears increase their short positions. This continued downward momentum discourages short sellers from exiting their winning trades, ultimately giving the bears control of the stock in these instances.

Measuring Short Interest

There are two main ways to gauge a stock’s short interest: the short-interest ratio, and short interest as a percentage of a stock’s total float. The short-interest ratio provides an estimate of how many days it would take an investor to buy back his shorted shares, at the stock’s average daily trading volume. To find the short-interest ratio, divide the number of shares sold short by the stock’s average daily trading volume during a one-month period. At Schaeffer’s, we label ratings about 5.0 (or one week to cover) as a sign of heavy pessimistic sentiment.

Short interest as a percentage of a stock’s total float also helps us determine the level of investor pessimism. A stock’s total float represents the total number of shares of a company available for trading. If a stock’s short interest equals or is more than 10% of the stock’s total float, this signals heavy pessimistic sentiment.