What is Short Interest?

Short interest is the number of shares sold short for a particular company or market that have not yet been recovered. It is expressed as a number or percentage and the short interest figure acts as an indicator of market sentiment i.e. it can tell you whether the market is bullish or bearish.

The concept of short interest is directly related to the concept of short selling - where traders sell shares that they do not own expecting the prices to fall and recover them at a later date to obtain a profit from their accurate prediction. The remaining number of shares or the number of shares that are not levelled off by these traders and are yet to be recovered or repurchased is known as the short interest.

An extremely high rate of short interest can indicate that investors are bearish or highly (overly in some cases) pessimistic about the future condition and price of that particular security. Volatile change or fluctuation in the short interest can also suggest a shift in investor mindsets to become more bullish or bearish (depending on the volume and direction of the change).

The process of shorting a stock involves 4 simple steps:

• Borrowing the stock

  The trader communicates with a broker that owns a large quantity of the security that they wish to short.

• Selling the stock

  The trader then proceeds to immediately sell the stock on the open market.

• Repurchase of the stock

  If all goes according to the trader's judgment, they will repurchase the stock at a later period when the price has declined. This process of repurchasing is referred to as short-covering.

• Return the stock

  In this stage, the trader will return the repurchased shares that the trader had borrowed from the broker. The trader will earn a profit amount equal to the difference between the selling price and the repurchasing price.

Short interest is not only an indicator used by investors, but also by companies to check the investor's confidence in their share prices. If a company sees that its short interest is extremely high then they can take action with the knowledge that investors expect their share prices to possibly dwindle in the future.

Difference between short interest and the Put Call ratio

Although both, short interest and the put call ratio are indicators of market sentiment, they aren’t one in the same thing. The focus of short interest is the number of short shares that are still outstanding. A higher rate of outstanding short stocks means a bearish market sentiment in this case.

However, the put/call ratio focuses on data derived from the options market. Puts are bearish bets and calls are bullish bets. Therefore, changes in the put/call ratio can be another tool to determine market sentiment and consumer expectations alongside short interest.

Limitations of short interest

Investors have an overall set of analytical tools through which they make financial decisions. Short interest is an addition to an investor's arsenal, it isn’t a one-stop-shop solution to finding the right stocks. Short interest also isn’t always a valid or effective indicator of market sentiment or direction since even major changes in short interest may not always lead to relevant changes in prices on time. Considering the validity of the data itself used by investors since short interest is published once a month by most exchanges, the data used by investors may always be slightly out of date.

How to use short interest?

Although there is a range of different ways a trader can use short interest, one of the most popular ways is to look out for stocks that have seen a major increase in short interest or have a high number of days-to-cover. The stock will then be under high selling pressure which would in most cases lead it to base out (this isn’t always the case). This approach can be utilized when paired with a tight stop loss to avoid and control any major risks.

Investors that are invested in a particular stock for the long run can also keep an eye on the short interest to see when their stock is becoming more bearish. In these situations, they can be prepared for a potential decline and take action accordingly.

The formula for short interest

There are two ways of expressing short interest, either as an absolute figure or as a percentage of float. The representation of short interest as a percentage is however considered more accurate for making investment decisions.

The formula for expressing short interest as a percentage is:

Short interest = No. of shares short and not covered / Share float

Conclusion

Short interest refers to the number of shares sold short that have not yet been recovered. This is also a tool for investors to read market sentiments and judge potential market direction. Now that you have the theoretical knowledge to read and make financial decisions based on short selling and short interest it’s time for you to put that knowledge to practical use! Create a trading account with IIFL today to excel your trading journey with more such Analysis using Trading App to trading.