What is a short interest ratio?
Discover what the short ratio means for stocks and how to use it.
If you’re thinking of buying a stock, then you’ll want to know all the latest gossip about that company. Is the share price a good deal, and will the company be successful in the future? Finding out more about the short interest ratio is part of that process. It helps you discover if traders think the share price will fall in the future. But what is short selling, and what do short interest figures tell you about a stock? Read on to find out more about this ratio and why it might affect your investing decisions.
What is short selling?
A short position is used to make money, when traders believe a stock is likely to drop in value. It works by traders borrowing a stock, selling it, and buying it back later at a cheaper price, before giving it back. A trader will only make money if the share price falls as expected. If instead the price goes up, a trader will end up losing money as they will have to buy the stock at a higher price than they sold it for.
What is the short interest ratio?
Short interest ratio is an investing term that helps you understand more about an individual stock. It shows if traders are “betting against” the stock price, by using a short position and aiming to make money if a share price falls in value.
The ratio takes the number of short-priced stocks currently held by traders and divides this by the stock’s average daily trading volume. This helps investors find out if a stock is heavily shorted.
Short interest ratio is also sometimes known as days to cover as it shows the total number of days it would take to cover or repurchase all the shares with current short positions.
Here’s how the ratio is calculated:
Short interest/ Average daily trading volume = Short interest ratio
Why is the short interest ratio useful?
The short interest ratio is useful as it gives you more information on a stock and if traders expect the share price to fall. The ratio changes based on the number of shares held in a short position and the trading volume.
If the ratio goes up, it could be a sign that many traders think the stock is overvalued. However, you should do your research as short interest figures lag up to 2 weeks behind the stock market, so information may be out of date.
Large movements in short interest or in the short interest ratio can provide lots of useful information to investors. If you’re researching a stock and notice a big change in short interest or a short interest ratio of over 10, then you may decide to do some further digging before making a purchase. It’s a good idea to try and work out why more investors are buying, selling or shorting this stock.
Where to find the short interest figures
You can usually find trading information, like the short interest ratio, on a stock exchange website or on a website with a stock quotes service. Be careful, because publicly available information tends to trail a few weeks or even months behind the actual trading figures.
An example of a how it works
Let’s look at some recent figures for Tesla shares, to show how a short interest ratio works.
On 15 February 2021 there were 40,042,086 Tesla shares outstanding with a short interest position and average daily trading volumes were 28,281,529 shares per day. This led to a short interest ratio of 1.42.
The latest available Tesla data at the time of writing is from 28 February 2022. There were 24,557,958 Tesla shares outstanding with a short interest position and average daily trading volumes were 27,432,417 shares per day. This led to a short interest ratio of less than 1, at 0.9. This low figure suggests that, at the end of February, not many traders expected the Tesla share price to fall significantly.
What is a high short interest ratio?
So how high is high and what is considered a high short interest ratio? Traders have different opinions on this, and it partly depends on the situation.
As a rough rule of thumb, a ratio of between 1 to 4 is fairly standard and shows short-sellers aren’t overly interested. In contrast, a figure above 10 indicates that traders are sniffing around and a company may be in trouble.
What is a low short interest ratio?
A low short interest ratio of between 0 to 4 suggests that not many traders think the share price will drop significantly. It could be a good sign if you’re looking to invest.
However, the ratio usually lags at least a few weeks behind the actual live stock market. More recent company problems might not be reflected in the data. Make sure you do your research and look at other investing ratios, data and information to make sure you’re not caught out.
Is a high ratio ever a buying opportunity?
Occasionally, when a stock is heavily shorted this can cause prices to surge. This happens when new information pushes the share price higher. This can force short-sellers to buy the stock to cover their positions, further stoking the stock price.
This phenomenon means that some experienced investors may hunt out stocks with a high short interest ratio. They’re looking out for stocks that may suddenly surge in price.
Limits of short interest data
If you want to know more about the short interest data on a stock, you should bear in mind that it has several limits.
Short interest ratio figures are not updated regularly and are only reported every 2 weeks. This means that there is often a time lag between the ratio and the current trading situation. And, in times of stock market volatility, the timing lag makes it almost impossible to work out what is really going on.
The ratio can also increase or decrease based on a stock’s average trading volume as well as the number of short positions. This means that the ratio sometimes decreases, even if short positions are increasing.
Let’s take a look at Tesla shares as an example. In July and August 2016, the Tesla short interest ratio rose despite the number of short positions falling. The fall in the ratio was deceptive because it was driven by the daily average trading volume falling off a cliff, rather than more traders shorting the share.
For the full picture on any stock, it’s a good idea to also take a look at the current level of short interest and stock trading volumes and search out any current market news.
If you’re a new investor, and you want to pick individual stocks, then investing in a stock with a high short interest ratio of over 10 could be risky. It suggests that traders think a stock is overvalued and might crash in price.
However, just looking at the short interest figures doesn’t give the full picture. For starters, they’re often out of date and lag a few weeks behind the real data. Instead of just looking at a single ratio, make sure you take a look at a range of data including any recent market information before investing.
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