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What Is Short Interest? Can Investors Profit From It?

What Is Short Interest? Can Investors Use It to Profit?

What Is Short InterestWhat is short interest? The term refers to the number of shares that have been sold short against a stock or security but have not yet been covered or closed out.  The value can be stated numerically or as a percentage.  Either way, it is a leading indicator of market mood. Extremely high short interest indicates that investors are extremely negative – even potentially overly-pessimistic. However, when investors are overly pessimistic, it can sometimes lead to very abrupt price increases. Large shifts in short interest might also indicate that investors are becoming more bearish or optimistic about a company.

A high percentage of short interest usually indicates that many investors believe the stock price will fall.  As a result, traders sell short hoping to buy the shares back later at a lower price.  However, when more than 10% of a company’s shares are shorted, the stock may become vulnerable to a short squeeze. The squeeze occurs when a stock’s upward movement is accentuated by short-sellers hurrying to buy the necessary shares to cover their short position. This frenzied activity can dramatically increase the stock’s daily volatility.  Selling short is always a risky strategy.  This is because when you short a stock, you have an unlimited downside.  In theory, a stock can continue to rise indefinitely. This is not true when purchasing a stock or going long.  Even if the stock drops to zero, the most you can lose is 100%.

What is Short Interest – A Closer Look

Short interest can reveal information about a stock’s potential future direction. It can also provide an indication of how bullish or bearish investors are about the market as a whole. Short interest is measured and reported by stock exchanges. Typically, they release reports at the end of each month.  This report provides investors with a tool to use as a benchmark for short-selling. At the middle and end of each month, the Nasdaq exchange issues a short interest report.

A significant increase or drop in short interest in a stock from the previous month may be particularly suggestive. For example, if short interest in a stock increases from 5% to 10%, it may be a sign that investor sentiment is turning negative on the company. The number of investors expecting the stock price to fall has more than doubled. At the very least, such a significant movement may prompt investors to look closer and conduct additional research.

Short Squeezes

Stocks with high levels of short interest are more vulnerable to short squeezes. Stocks with lower floats and heavy short interest are particularly vulnerable to a short squeeze.  Each new short position reduces the number of available shares to cover short positions. However, an extreme reading may differ from one stock to the next. A strong corporation with a long history of consistent profit creation may have extremes near 10%.  Whereas, more speculative companies may see short interest consistently reaching above 30% as a common occurrence.

In either case, when a stock reaches an extreme, it may indicate a potential short squeeze. A short squeeze is an upward price movement driven by investor buying.  However, that demand is combined with short sellers being pushed to cover their holdings to avoid a huge loss.

Days-to-cover

Short interest can also be expressed as a ratio known as days-to-cover. To arrive at the figure, divide the number of short shares by the average daily trading volume. For example, consider a company with two million shares short and the typical daily trading volume is 200,000 shares.  In that instance, it will take at least ten days for the shorts to cover their positions. The longer the days to cover, the more negative investors are.  However, the larger the short squeeze if they are incorrect.

Days-to-cover analysis can be performed on individual equities or on the entire market. An investor might use the days-to-cover of all Nasdaq stocks to measure the overall stock market.  Simply by dividing total short interest by average daily Nasdaq trading volume.

What is Short Interest as an Indicator for Investors

If short interest on a specific investment rises, this does not mean the price is certain to fall soon. It only means a higher number of investors are expecting the price of the investment or security will fall. Furthermore, some investors will sell a short position in order to protect another long one. Increasing levels of short interest may motivate long investors to perform more in-depth research.  They will want to ensure they understand what is prompting others to bet against the stock.

An Indicator of Market Sentiment

Undeniably, many investors do sell short because they believe the price of a specific investment will fall. As a result, a high level of short selling may indicate that investor sentiment is gloomy. However, high short interest is regarded by some contrarian investors as an indication that market sentiment is overly negative. To a contrarian investor, this can be interpreted as a bullish signal. Moreover, some investors gamble on equities with high short interest. This is because they understand that those short-sellers will eventually have to repurchase the stock to cover their shorts.   To them, this is an assurance that there will be guaranteed upside demand in the near future.

Examples of How Investors can use Short Interest

Short interest can be employed in a variety of ways. Look for equities with big spikes in short interest or a high number of days to cover for traders interested in short squeezes. The stock must then bottom out since it will almost certainly face severe selling pressure, although not always. A long transaction would be considered only once the price begins to rise. To control risk, this strategy should include a tight stop loss.  Also, trades should normally be regarded as short-term in nature.  Always consider that there may be solid grounds for investors’ initial bearishness.

An investor who is long a stock may want to monitor short interest as well. If short selling rises, it may indicate that investors are getting more concerned about the stock or the stock market as a whole. In either instance, it alerts the investor to either protect profits or brace for some potential downside.

What is Short Interest vs. the Put/Call Ratio

The put/call ratio and short interest are both measures of market mood. The quantity of outstanding short shares is the subject of short interest. The put/call ratio gets its input from the options market. Put options are considered bearish bets, whilst calls are considered bullish wagers. Changes in the put/call ratio are thus another indicator that may be used to identify whether investors expect future prices to climb or fall.

Limitations of Using Short Interest

Short interest can be informative and beneficial.  However, it should not be used as the sole determinant of an investment choice. It is another piece of information to include in an investor’s overall analysis. Short interest movements, and even extremes, may not result in major price changes in a timely manner. A stock can remain at an extreme reading for extended periods of time without experiencing a short squeeze or a significant price decrease. Furthermore, increased short interest does not significantly correlate historically with many large price falls.

Most exchanges publish short interest once a month.  However, Nasdaq publishes it twice a month. As a result, the information traders use is always slightly out of date.  In fact, actual short interest may already be much different than what the report shows.

Up Next: What Is Unearned Income?

What is Unearned Income Unearned income is also referred to as passive or deferred income.  It is income from investments and other sources unrelated to direct employment or owning a business. For example, earned income comes from working a regular job providing a product or service and receiving compensation in the form of wages, tips, or a salary.  In contrast, unearned income doesn’t require direct participation. Lower tax rates usually apply to unearned income. Examples of unearned income include interest from savings accounts, bond interest, alimony, and dividends from stocks.

Unearned income is a term used by the IRS to define income that is derived from means other than personal effort. The IRS considers wages, tips, salary, and other taxable compensation to be earned income. Income that does not meet these criteria is considered unearned. Knowing the difference between unearned income and earned income is important because the two are taxed differently. While unearned income is frequently subject to taxes, it is typically not subject to payroll taxes. For example, earned interest is not subject to payroll taxes, but is frequently subject to a capital gains tax. Unearned income also is not subject to employment taxes, like Social Security and Medicare taxes. Some unearned income, such as life insurance proceeds, are not taxed at all.

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