What is Short Interest?

Key Highlights

• The number of shorted shares divided by the average daily trading volume gives the short interest ratio. The figure indicates the number of days that investors would need to use to liquidate their short positions on the open market.

• A high short-interest ratio indicates that investors have a bearish outlook. A low short-interest ratio suggests a positive sentiment among investors.

• An increase in the short interest ratio indicates that a stock has more chances of a short squeeze.

• Typically, an increase in short interest indicates a bearish market sentiment. Conversely, a decrease in short interest shows a bullish sentiment.

Short Interest Meaning

Let’s begin with the short interest definition. Short interest refers to the total amount of outstanding shares sold short. Shares that are not repurchased to close the short position are the outstanding shares. Traders usually sell short when they believe a security's price will drop soon.

Short selling and short interest have a direct relationship. An investor who engages in short selling borrows and then sells shares of an asset. He expects to repurchase the asset later at a lower cost. After that, the short seller gives back the borrowed security to his broker.

Process of Shorting a Stock

Here's how to short a stock:

1. Borrowing a Stock

Usually, the trader gets in touch with the broker. Brokers locate an investor willing to lend their stock. They promise the lender to return the stock on a predetermined date. Additionally, the broker has the option to lend the stock from its own holdings. The trader pays a fee or interest to the broker for borrowing the stock.

2. Offloading the shares

After getting the stock, the trader will immediately sell it on the open market.

3. Stock Repurchase

The trader will buy back the shares cheaper when their value drops. Short covering is the act of buying back a shorted stock.

4. Returning the Stock

After repurchasing the stock, the trader will return it to the broker. The difference between the selling and repurchasing price of the stock is the profit. However, the trader will lose money if the stock price increases after they sell short. This is because they would have to pay a higher price to repurchase the shares.

Steps 2-3 of the process create short interest when the trader sells the stock but hasn't yet repurchased it.

Formula of Short Interest

Divide the number of shares sold short by the total shares available for purchase to determine the short interest of a stock. Short interest is also known as the short float percentage. It is the percentage of the float that is borrowed.

Number of Shares Sold Short / Number of Shares in Float = Short Interest

Example: Let’s consider a scenario where a business has 30 lakh shares sold short. Its total outstanding shares are 1.50 crores.

Short Interest = No. of shares short sold/ shares in float = 30,00,000 / 1,50,00,000 = 5%

Understanding the Market Sentiment with Short Interest

An increasing amount of short interest does not always indicate that the security price will drop shortly. It indicates that more investors believe the security's price will fall.

Several investors sell short because they anticipate a decline in the price of a specific security. Therefore, a high level of short interest may indicate a negative outlook among investors. Some investors see high short interest as a bullish indicator. They believe it indicates that market sentiment is very negative.

How to Use Short Interest?

Now that you know the short interest meaning, let's find out how to utilise it. A trader can use the short interest in a variety of ways. Here are some of the best ones.

• One of the popular strategies is to look for companies with a significant increase in short interest. After that, there will be intense selling pressure on the stock. It will often cause it to break out. However, this may not be always the case. This strategy can help manage risks when used along with a tight stop loss.

• Long-term investors can also monitor short interest to determine whether a stock is bearish. In these circumstances, they can be ready for a possible downturn and adjust their strategy accordingly.

Limitations of Short Interest

Short Interest can serve as a valuable indicator of the prevailing market sentiment. Yet, short interest does have a few drawbacks. The following are the notable ones.

1. Report updates are irregular: Most exchanges provide short interest reports only once a month. However, the market can rapidly change at any time. Such reports may not be relevant to the constantly evolving trends.

2. Unreliable signals: Variations in short interest rarely provide early warning of significant market movements. Likewise, a stock may be severely shorted for a long time without a price decrease or short squeeze.

Conclusion

Short interest is a ratio of the outstanding shares to the total shares. Increasing short interest does not always indicate that a stock price will fall. It just shows that several investors believe that prices will go down. Short interest may be a helpful tool for traders and investors to know the market sentiment. However, you should not depend only on it to make financial decisions. Take into account other market indicators to assess a market. Remember, a comprehensive analysis is essential for successful trading.