DEFINITION:
The short interest ratio is a measure that tells you how many days it would take for investors to cover their short positions in the open market. It is calculated by dividing the number of shares that have been shorted for a company by the stock's average daily trading volume. This ratio gives insight into the potential time frame for investors to buy back or "cover" their short positions.
The short interest ratio is a calculation made by dividing the number of shares that investors have shorted for a stock by its average daily trading volume. This formula helps determine the number of days it would take for investors to buy back the shares and settle their existing short positions.
To grasp why the short interest ratio matters, it's essential to understand how shorting a stock works. When investors short a stock, they borrow shares from their broker and immediately sell them, hoping the price will decrease. Profits come if the stock's price falls, allowing them to buy back the shares at a lower price. However, if the stock rises, potential losses are unlimited, as there's no cap on how high prices can go. To limit losses, short sellers prefer a quick repurchase of shares. A higher short interest ratio means it takes longer to close out short positions.
A high short ratio usually means that investors are pessimistic and anticipate the stock price to fall. In contrast, a low short ratio indicates optimism, suggesting that investors expect the stock price to rise.
To calculate the short interest ratio, you need to know:
1. Short interest: The total number of a company’s outstanding shares that have been shorted.
2. Average daily trading volume: The average number of shares that are traded each day.
The short interest ratio formula is as follows:
Short interest ratio = Short interest / Average daily trading volume
Suppose investors have shorted 3,000 shares of Company ABC’s stock. The company’s average daily trading volume is 2,000.
Applying this formula to Company ABC, we get:
ABC’s short interest ratio = 3,000 shorted shares / 2,000 average daily trading volume = 1.5 days to cover
If the number of short positions in the stock doubles, the short interest ratio would also double. Similarly, if the number of shorted shares stays the same but the average daily trading volume decreases by half, the short ratio would double as well.
Take Bed Bath & Beyond as an example in the first five months of 2021. Around January 15, 2021, about 75 million shares were shorted, and the average daily trading volume was slightly over 17 million. This gave a days-to-cover ratio of 4.4.
By mid-May 2021, the number of short positions had fallen to less than 33 million. However, the average daily trading volume plummeted by more than 80% during the same period, reaching just over 3 million. Consequently, Bed Bath & Beyond's short-interest ratio increased to 10.7. This means it would take 10.7 days to cover all short positions for the retailer's stock, an additional 6.3 days compared to mid-January.
The more days it takes to cover, the more exposed a stock is to a short squeeze. A short ratio of seven days or more indicates that short sellers might face challenges closing out their positions.
The short-interest ratio can go above 100% because the same shares can be borrowed and shorted multiple times.
Finding short interest information is quite straightforward. According to rules from the Financial Industry Regulatory Authority (FINRA) and U.S. stock exchanges, brokerage firms must report short positions to FINRA twice a month. Platforms that offer real-time stock market information, such as Yahoo Finance, make it easy to locate details about short positions and trading volume when you search for a stock's ticker symbol.
Investors can also use the short interest ratio to assess whether the overall stock market outlook is bullish or bearish. The NYSE short interest ratio provides information for the entire New York Stock Exchange. Monthly short interest data for all NYSE indexes is published by the NYSE.
To calculate the short interest ratio, divide the total number of outstanding shorted shares across the entire exchange by the average daily trading volume of the NYSE for the past month.
Knowing the level of short interest in a stock can tell you a lot about how other investors perceive it.
The amount of people betting against a stock (short interest) or the ratio of these bets (short interest ratio) doesn't necessarily control how a stock will move. Even if many people are betting that a company's stock will go down, the stock can still go up and make investors money. It's not a strict rule that high short interest means a stock will perform poorly.
It's crucial to know that info about how many people are betting against a stock (short interest) can become outdated quickly, especially in a wild market, as this data is reported only twice a month. If a stock has a high short interest ratio, it means there's more risk in betting against it. If the stock price suddenly goes up, those who bet it would go down (short sellers) usually want to close their bets fast to avoid big losses.
The short interest ratio is also useful even if you haven't bet against a stock. For instance, if you own stock in a company with a high short ratio, you could potentially make a profit when a short squeeze happens and share prices rise. But predicting short squeezes is tough. If short sellers are right about the stock going down and its price falls, you could lose a lot of money as a shareholder.
For regular investors, it's smart to be careful when dealing with stocks that have a high short interest ratio, whether you're buying or betting against them.
