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Short Interest Shines Light on Investor Sentiment

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Breaking down short interest as a contrarian indicator.

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In a utopian world, all stock prices would infinitely trend upward, allowing investors to earn an immense profit. However, the reality is that a stock's performance fluctuates in response to the interaction between supply and demand. Sometimes, a stock will naturally trend lower, and as traders have become more sophisticated, more ways have emerged to bet on this downside. One method is by shorting the stock.

When an investor expects the price of an underlying stock to decline, they may choose to execute a short sale. In other words, they sells shares of a stock that they borrowed from their broker, in hopes that the stock price will head south. If their expectations are met, the short seller will profit by buying back the shares of that stock for a cheaper price. They would then extinguish their short position by returning the borrowed shares.

The total number of a particular stock's shares that investors have sold short but have not yet covered or closed out is known as short interest. Brokerage firms, twice a month, must report the number of shorted shares across their clients' accounts. At Schaeffer's, we like to use this data to measure the relative bearishness of investors toward a specific stock, and to make predictions about whether said stock could be a candidate for "short covering," which is what transpires when short sellers begin to buy back the shares (whether at a cheaper price or otherwise).

Short interest is often expressed as a percentage of the given stock's total float, which is calculated by dividing the number of shares sold short by the total number of a shares a company has available for trading. All other factors being equal, we tend to view this indicator as "low" if below 4%, "healthy" if between 4%-5%, and "high" if above 5%.

Another popular way to express short interest is via the short interest ratio (SIR), calculated by dividing the number of shares sold short by the stock's average daily trading volume over the course of a month. Options traders use this ratio to roughly estimate the number of trading days it would take for the short sellers to repurchase all of their borrowed shares and close out their short positions, should there be a rush to do so. Again, this ratio is generally viewed as "low" if below 5, and "high" if above 5.

Depending on the price action of the underlying stock, high short interest can be taken as a bullish or bearish signal. A downward-trending stock facing heavy short interest could suffer additional losses as more investors short-sell their shares, creating the perfect opportunity for bearish traders to gain a profit.

On the other hand, if the stock is in the midst of an uptrend, heavy short interest could lead to a short squeeze, which occurs when demand for a stock increases as short sellers try to exit their trades. This becomes a self-perpetuating cycle, causing the stock to inevitably trend upward. Short sellers then further increase the stock's demand (and price) by buying back their shares in an effort to cut losses, allowing bullish traders to capitalize off of the temporary jump.

As mentioned earlier, we at Schaeffer's use short interest as a measurement of investor pessimism toward a certain stock, and a gauge of whether there could be future demand from short sellers. However, keep in mind that arbitrage situations -- such as mergers and the release of convertible bonds -- can also lead to inflated short interest; therefore, to gain a more accurate reading, consider other sentiment indicators as well.

This article by Milissa Hudepohl was originally published on Schaeffer's Investment Research.

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