Stock prices fluctuate because of supply and demand. High demand for a stock causes its price to go up. Too much supply causes a stock’s price to decline. Investors buying and holding a stock until it appreciates is a common practice. However, some investors profit when the value of a stock goes down, referred to as short selling. Short interest reflects the number of investors who expect the price of stock to decline.
When an investor shorts a stock, he expects its price to decline. To short a stock, he borrows money using a margin account to buy the shares at a high price. The stock may come from the broker’s inventory, another customer or another brokerage firm. To close the short position, the investor must buy the stock back called “covering.” If the stock drops in price, the investor gets to buy the shares at a lower price, making a profit on the difference. If the stock increases in value, the investor has to buy the stock at a higher price, which means he loses money.
When demand increases for a stock that has a lot of short interest, it causes the price of the stock to rise. In such a case, short sellers must cover their short positions to avoid losses by repurchasing the shares. This event is called a short squeeze. This causes a spike in demand for the shares sending the price even higher. As the short interest investors reverse their positions, the price increases, in some cases substantially.
The short ratio is a metric that investors use to gauge sentiment on a particular stock or the overall market. The ratio divides the number of shares sold short by the average daily trading volume. The ratio represents the number of days it takes short sellers on average to repurchase the borrowed shares. If an exchange has a short interest ratio of 5 or higher, this signifies a bearish sentiment, meaning investors expect the market to decline or see stocks as overpriced. You can track the short ratio in a stock by looking up its stock symbol on a financial website or stock exchange where the stock is listed. Track the ratio over time to get a sense of how investors fell about the stock or overall market.
Short sellers getting into and out of a stock may or may not influence the share price. For example, a short squeeze is more likely to happen with small capitalization stocks than large ones. Capitalization refers to the number of shares a company has outstanding multiplied by the company’s stock price. A short squeeze is also most likely to affect stocks with small public float: the number of shares available to trade. With fewer available shares to trade, heightened short interest can cause significant downward pressure on a stock; the opposite is true if shorts have to cover their position in a stock with little float.