Short interest refers to the number of shares sold short but remains in the market. Most traders sell their securities short when they believe that the price will fall by taking out loans to purchase shares of stock. The investor then sells the securities to buyers willing to pay the market price.

Short interest is typically an indicator of market attitude. A rise in short interest typically indicates that investors are becoming bearish, whereas a decrease in short interest indicates that they are becoming more optimistic. Short interest is usually expressed in terms of a number or percentage. FINRA obliges firms to disclose short interest balances on all proprietary and customer accounts for all equity securities at least twice per month.

Art of Short Selling

The practice of short selling can be described as the reverse of investing in stocks. It's selling an investment that the seller doesn't own with the expectation of seeing the value decrease. If you believe that a certain price of a security, say the shares of a struggling company, could fall, you can take the stock from your broker-dealer, then sell it, and receive the proceeds of the sale. If, over a long period that passes, your price decreases.

The problem is that you'll lose money when the stock price is pushed up. This is because you need to purchase the stock at a greater price. Additionally, the broker-dealer may require that the stock be closed at any point regardless of the value of the stock. However, this usually happens only when the broker or dealer believes that the creditworthiness of the creditor is risky for the business.

Short Interest Shows Sentiment

Short interest refers to the sum of shares of a certain stock sold short by investors but not yet covered or removed from the market. It can be expressed as either a number or a percent. When expressed in terms of a percentage, short interest is simply the number of shares shorted times the remaining shares. In other words, a share with 1.5 million shares shorted with 10 million outstanding shares has an interest short of 15 percent (1.5 million/10 million = 15 percent).

Most stock exchanges monitor each stock's short interest and issue reports released at the end of each month; however, Nasdaq is among the ones that report regularly. These reports are beneficial for traders since they permit investors to assess the general mood of the market for a certain stock by revealing what short-sellers have been doing.

News Drives Changes in Short Interest

A dramatic change or reduction in the company's short interest over the prior month is an informative indicator of the mood of investors. Microsoft's short interest was up by 10% in one month. This means there was an increase of 10% in the number of investors who think the stock's price will fall. A significant change like this is an incentive for investors to research more. It is important to look over the latest research and any recent news articles to find out what's going on with the company and what is driving why investors are selling their shares.

Stocks with high short interest must be taken with extreme care; however, avoiding them at all costs is not necessary. Short-term traders (like most investors) aren't flawless and be in error. Indeed, many non-contrarian investors utilize shorter interest rates to assess which direction to take in the market. The reasoning behind this is that if everyone else is selling, the stock stands at its lowest and is only able to move up. Therefore, those who believe that an increase in the short-interest ratio is a good sign because, in the end, there will be substantial upward pressure on the price of the stock as short-sellers take over those short-sellers.

Understanding the Short-Interest Ratio

The short-interest ratio is the amount of shares sold for short (short rates) divided by the average daily volume. It is also referred to as "the "days-to-cover ratio" because it calculates, based upon the volume of trading average for the stock and the amount of time it will take for short sellers to pay off their positions in the event of positive information about the company boosts the price.