Last Updated on 7 April, 2022 by Samuelsson
What Is Short Interest Ratio? – Definition and Explanation
Investors typically buy stocks in anticipation of a rise in share prices, but some, especially short-term traders, also short-sell stocks when they think that the prices are going to tank. There are indicators used to gauge the activities of short-sellers, and the short interest ratio is one of them. But what does the short interest ratio mean?
The short ratio is the number of shorted shares of a company divided by the stock’s average daily trading volume. It shows the number of days it would take investors to close out short positions in the open market. Thus, it can be an indicator to gauge investor sentiment regarding a stock or the market as a whole.
To make the topic easy to understand, we’ll discuss it under the following subheadings:
- Short interest ratio: definition
- Short interest ratio: explanation
- What can the short interest ratio tell you?
- What is considered a high short interest ratio?
- How to use short interest ratio in making trading decisions
- An example of short interest ratio in action
- The disadvantages of using short interest ratio
Short interest ratio: definition
Also known as short ratio or days to cover, short interest ratio is the number of shorted shares of a company divided by the stock’s average daily trading volume, generally over the last 30 trading days. It is a quick way to see how heavily shorted a stock is compared to its average daily trading volume. So, it can be used to estimate the average number of days it would take investors to cover (buy back) their short positions in the open market, which is why it is also referred to as the days-to-cover ratio.
The ratio is seen as an indicator to gauge investor sentiment regarding a stock. It is used by both fundamental and technical traders to identify trends. Apart from individual stocks, the ratio can also be calculated for an entire exchange to determine the sentiment of the market as a whole. A high short interest ratio in an exchange may indicate a bearish sentiment in the market, while a low ratio may indicate bullishness in the market.
What this means is that when the short interest ratio is high, the number of shares that will be repurchased in the open market after short selling is high, and would be more difficult to cover. Likewise, if the short interest ratio is low, it means that the number of shares that will be repurchased in the open market after short selling is low and can be done quickly.
Since news or events may impact trading volumes and make the ratio expand or contract, you should always compare the ratio with the actual short interest and trading volumes. Note that the short interest ratio and short interest are not the same, as short interest only measures the total number of shares that have been sold short in the market.
Short interest ratio: explanation
To better explain this ratio, let’s first explain how short selling works in stocks. In the stock market, short selling is the opposite of buying. So, when you sell a stock short, you are basically borrowing shares from your broker and immediately selling them in hopes that the price will drop. Because you now owe your broker the number of shares you borrowed, you’ll eventually have to buy them back. If the share price drops, you make profits from your short positions when you buy back the shares for a lower price and return them to your broker. Your profit is the difference between the price at which you sell the shares and the price you buy them back.
However, if the share price rises, you lose. Since there’s no limit on how high share prices can rise, you can theoretically lose an infinite amount of money from a short position. Owing to this potential to incur large losses, short sellers prefer to be able to repurchase shares quickly to close out their positions to avoid getting hurt from a short squeeze.
A short squeeze is a situation where the price of a stock with a high short interest begins to have increased demand and a strong upward trend. When this happens, short-sellers try to cut their losses by buying the shares to cover short positions, and in doing so, may add to demand, thereby causing the share price to further escalate temporarily. However, in markets with an active options market, short-sellers can hedge against the risk of a short squeeze by buying call options.
Note that short squeezes are more likely to occur in stocks with small market capitalization and a small public float. For such stocks, when the short interest ratio is high, it will take a longer time for short sellers to cover their short positions because the average daily trading volume is usually small.
How to calculate short interest ratio
The short interest ratio is calculated by dividing the total number of shorted shares of a stock by the average daily trading volume (ADTV). The formula is given as follows:
SIR = SI/ADTV
SIR = short interest ratio
SI = short interest (number of shares sold short)
ADTV = average daily trading volume
For example, let’s say that 20 million shares of a company’s stock are sold short and the stock’s average trading volume is 2.5 million shares. In this case, the short ratio would be four days — 20 million / 2 million = 8 days. This means that if all of the shorts wanted to cover their positions at the same time, it would take around 8 days for them to do so.
As you can see, the short ratio tells investors approximately how many days it would take short sellers to cover their positions if they are facing a short squeeze (the price of the stock suddenly rises). The higher the short ratio, the longer it will take to buy back those borrowed shares. To break it down, if the stock is not liquid enough (low daily trading volume), it would take a longer time for short sellers to cover their shorts. If the ratio is low, it means that short-sellers could easily and quickly cover their positions.
The NYSE short interest ratio
Apart from the short interest ratio for individual stocks, it is possible to get the short interest ratio of an entire exchange, such as the NYSE short interest ratio. In this case, the short interest ratio is calculated by taking the number of shares sold short on the entire NYSE and dividing it by the average daily trading volume on the NYSE for the previous 30 days.
For example, let’s say that there are 10 billion shares sold short on the NYSE, and on average, about 2 billion shares were traded each day over the past 30 days. The NYSE short interest ratio would be 5 days: that is, 10 billion ÷ 2 billion = 5. This means that it would take an average of 5 days to cover the entire short position on the NYSE if the exchange were to maintain the same average daily trading volume.
A high exchange-wide short interest ratio means that the sentiment in the entire stock market is bearish. This often happens during a bear market or when a market crisis is imminent and most institutional traders are short.
Short interest ratio vs. short interest
It’s important to not confuse the short interest ratio with short interest. While short interest is the number of tradable shares of a company sold short relative to the total number of the company’s outstanding shares trading on the market (the float), the short interest ratio is the ratio of short interest to the average daily trading volume.
The short interest ratio is a formula used to measure how many days it would take for all the shares short in the marketplace to be covered. Thus, while short interest is a part of the short interest ratio, it is not the same as the ratio. The main difference between them is that the short interest ratio takes liquidity into account since it considers the average daily trading volume. On the other hand, short interest does not take the average daily trading volume (liquidity) into account.
Although both can tell you about the sentiment of the market, short interest can be measured as a percentage of the company’s float. It is calculated by dividing the number of shares sold short by the total number of shares available for trading (the public float).
For example, let’s say that there are 10 million shares of XYZ corporation, but 1 million of these shares are held by company officers and aren’t tradable. In this case, the public float of the company’s stock is 9 million shares. If 900,000 shares are sold short, short interest is calculated by dividing the 900,000 shares sold short by the 9 million of the company’s public float. This gives us a short interest ratio of about 0.1 or 10%.
When short interest as a percentage of the float is above 50%, it means that short-sellers would have a very difficult time covering their positions if the price were to rise because the majority of shares have been sold short already. In this case, they would have to compete with each other to buy the shares back if they wished to cover their positions.
What can the short interest ratio tell you?
The short interest ratio can provide valuable information about how investors feel about a stock or the entire market. The ratio depends on two factors: short interest and average daily trading volume. So, the ratio can rise or fall based on the number of shares short, and it can also increase or decrease as volume levels change.
When the total short interest is high, the ratio is high, and when the total short interest is low, the ratio is low. On the other hand, when the average daily trading volume is high, the short interest ratio is low, and when the average daily trading volume is low, the short interest ratio is high.
In fact, the short ratio tells investors how high or how low the shorted shares are compared to the average daily trading volume. A high short interest ratio means that the number of shares that will be repurchased in the open market after short selling is high. Likewise, a low short interest ratio means that the number of shares that will be repurchased in the open market after short selling is low.
Be careful when buying or selling a stock with a high short interest ratio. The higher the short interest ratio, the greater the risk of taking a short position because, when there’s a short squeeze, short-sellers would hustle to close out their positions quickly to minimize losses. Even if you are long and think you can benefit from a short squeeze, it is often a madhouse — the short sellers can fight back and push the stock lower.
What is considered a high short interest ratio?
The idea of a high short interest ratio is relative; there is no particular cutoff level to show how high should be considered “high.” Most investors tend to compare the value of similar stocks to have an idea. Nonetheless, experienced options traders tend to use the following rules to guide their analysis:
- A short interest ratio of between 1 and 4 is usually considered low — the sentiment in the stock is strongly positive
- A ratio of above 10 is considered high, which means there is extreme pessimism in the stock
Since the NYSE short interest ratio has been gradually falling since the late 1990s, there’s no long-term level that can be identified as “high.” However, over the short term, there can be upward spikes in the ratio, which may indicate pessimistic sentiment towards the U.S. economy as a whole.
How to use short interest ratio in making trading decisions
Since the short interest ratio can give you some insight into the sentiment of the market, it can help you in making trading decisions. For example, when a stock’s short ratio is trending higher, then it may be a sign that investor sentiment in the company is declining. In this case, you should see it as a warning sign, and if you’re long, it may be time to reevaluate your position and consider selling. In fact, a study from MIT and Harvard in 2004 found that stocks with the highest short interest ratios underperformed by 15% per year on average.
On the other hand, if a stock’s short interest ratio is quite low, investor sentiment in the stock may be improving, so the stock price may have a good chance of going up. However, note that the short ratio on its own is not necessarily an accurate predictor of market direction; the ratio does not dictate the actual movement of stock prices. A company with a high short interest may still be able to deliver positive returns, while the one with a low short ratio can deliver negative returns.
As with all metrics used in stock analysis, the short interest ratio should be combined with other indicators. But more importantly, try to get into details about the situation of the company behind the stock. For example, when there are many short-sellers in a stock, it could be that the company is not very profitable, is facing market changes that have made its business model untenable, or the management is involved in accounting scandals.
However, some traders may interpret a high short interest ratio as a sign that the stock is may be trading at a bargain. Moreover, stocks with a high short interest ratio have the potential for sudden rallies, which is why many experienced options traders consider the metric to be a bullish indicator.
An example of short interest ratio in action
The Apple (AAPL) chart below shows the short-interest ratio, short interest (the number of shares short), and the daily trading volume. From the chart, you can see that a rising short interest ratio does not always correspond to rising short interest and neither does a falling ratio always correspond to a falling short interest.
On April 5, 2021 (pink dotted line), the short interest ratio was rising despite short interest being stagnant, because the daily average volume was down during that time. By the ending of April 2021 (blue dotted line), the short interest ratio was declining despite short interest being elevated — the reason was that there was a higher rise in the daily volume.
The disadvantages of using short interest ratio
Despite the uses, the short interest ratio has several flaws; these are some of them:
The frequency of its updates is poor: The data is reported only twice in a month — usually on the 15th day and the last day of the month. Since it takes several days before the information is updated, by that time it is done, the number of short positions may have already changed.
Market news and political events can affect it: If you want to use the ratio, you need to consider how news or events may impact trading volumes and make the ratio expand or contract. You should always compare the ratio with the actual short interest and trading volumes to get the full picture.