Short selling allows a person to profit from a falling stock. How could someone profit from a stock decreasing in value?

Well, the existence of this ability to short sell a public stock should not come as a surprise as stock prices are constantly rising and falling. Thus, there are brokerage departments and market firms whose sole purpose is to research deteriorating public companies that are prime short-selling candidates. These firms pore over financial statements looking for any weaknesses that the public market may not have discounted yet or a company that is simply overvalued. One factor they look at is called short interest, which serves as a market-sentiment indicator, and well cover it in detail in this article.

Short Selling Summary

Essentially, short selling is the exact opposite of buying public stocks its the selling of a security that the seller does not own, done so in the hope that the stock market price of the stock will fall. If you feel a particular securitys price, lets say the stock of a struggling company, will fall, you can borrow the stock from your broker-dealer, sell it and get the proceeds from the sale. If, after a period of time (e.g. 1, 2, 20 days) the stock price declines, you can close out the position by buying the stock on the open market at the lower price, return the stock to your dealer-broker and realize a gain.

Sounds easy? Its not as simple as that there is a catch to short selling. If the stock price rises, you lose money since you have to buy the stock back at a higher price. And the dealer-broker has the discretion to demand that the position be closed out at any time, regardless of the stock price. However, this demand typically occurs only if the dealer-broker feels that the creditworthiness of the borrower is too risky for the firm.

Short Stocks Interest Reports

Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. This can be expressed as a number or as a percentage.

NASD Rule 3360 has been expanded to require NASD member firms to report their short positions on all over-the-counter (OTC) equity securities to NASD Regulation, on a monthly basis. Once the short position reports are received, the short interest is then compiled for each OTC security. Firms are required to report their short positions as of settlement on the 15th of each month, or the preceding business day if the 15th is not a business day. The reports must be filed by the second business day after the reporting settlement date. The short interest data is compiled and provided for publication on the 8th business day after the reporting settlement date.

When expressed as a percentage short interest is the number of shorted shares divided by the number of shares outstanding. For example, a stock with 1.5 million shares sold short and 10 million shares outstanding has a short interest of 15% (1.5 million/10 million = 15%).

* Most stock exchanges track the short interest in each stock and issue reports at months end. These reports are great because, by showing what short sellers are doing, they allow investors to gauge overall market sentiment surrounding a particular stock. Or alternatively most exchanges provide an online tool to calculate short interest for a particular security.

Reading Short Interest Reports

A large increase or decrease in a public stocks short interest from the previous month can be a very telling indicator of investor sentiment. Lets say that Microsofts (MSFT) short interest increased by 10% in one month. This means that there was a 10% increase in the amount of people who believe the stock will decrease. Such a significant shift provides good cause for us to find out more. We would need to check the current research and any recent news reports to see what is happening with the company and why more investors are selling its stock.

A high short-interest stock should be approached for buying with extreme caution but not necessarily avoided at all cost. Short sellers (like all investors) arent perfect and have been known to be wrong from time to time. In fact, many contrarian investors use short interest as a tool to determine the direction of the market. The rationale is that if everyone is selling, then the stock is already at its low and can only move up. Thus, contrarians feel that a high short-interest ratio (which we will discuss below) is bullish because eventually there will be significant upward pressure on the stocks price as short sellers cover their short positions (i.e. buy back the stocks they borrowed to return to the lender).

Short-Interest Ratio

The short-interest ratio is the number of shares sold short (short interest) divided by average daily volume. This is often called the days-to-cover ratio because it tells, given the stocks average trading volume, how many days it will take short sellers to cover their positions if positive news about the company lifts the price.

Again, lets assume Microsoft has a short interest of 75 million shares, while the average daily volume of shares traded is 70 million. Doing a quick and easy calculation (75,000,000/70,000,000) we find that it would take 1.07 days for all of the short sellers to cover their positions. The higher the ratio, the longer it will take to buy back the borrowed shares an important factor upon which traders or investors decide whether to take a short position. Typically, if the days to cover stretch past eight or more days, covering a short position could prove difficult.

Short Squeeze?

Some bullish investors see a high short interest as an opportunity. This outlook is based on the short-interest theory. The rationale is, if you are short selling a stock and the stock keeps rising rather than falling, youll most likely want to get out before you lose your shirt. A short squeeze occurs when short sellers are scrambling to replace their borrowed stock thereby increasing demand and decreasing supply, forcing prices up. Short squeezes tend to occur more often in smaller cap stocks, which have a very small float (supply), but large caps are certainly not immune from this situation.

If a stock has a high short interest, short positions may be forced to liquidate and cover their position by purchasing the stock. If a short squeeze occurs and enough short sellers buy back the stock, the price could go even higher. Unfortunately, however, this is a very difficult phenomenon to predict.

Conclusion

Although it can be a telling indicator, an investment decision should not be based entirely on a stocks short interest; however, investors often overlook this ratio despite its widespread availability. Unlike the fundamentals of a company, the short interest requires little or no calculations. Half a minute of time to look up short interest can help provide valuable insight into what sentiment investors have towards a particular company or exchange.

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