Short interest is the selling of a security that the seller does not own. It can be strange to think, ‘how can I sell something I don’t own’. However, this is how it works:
- You borrow shares of a stock from a broker and sell them on the open market.
- You hold the money you received from selling the shares.
- If the price of the stock falls, you buy back the shares at the lower price (and return them to the broker)
- You keep the difference between the price you sold the shares for and the price you bought them back for as your profit.
- However, if the price of the stock goes up instead of down, you'll have to buy back the shares at a higher price, resulting in a loss.
Inflation
So, some traders will monitor the amount of short interest in a stock as a sentiment indicator. When lots of people are selling the stock it shows that sentiment is negative. They track this by looking at an indicator known as ‘Days to Cover’. Brokerage firms must report their short positions on the 15th of each month and a public report comes out 8 days later. The way it is calculated is like this:
Aggregate monthly short interest/average daily share volume = Days to Cover ratio.
The ratio can also be used as a contrarian indicator too. So, for example, if the Days to Cover ratio is high (indicating bearish sentiment), but some positive news comes out those short sellers will suffer losses. They may decide to cover their shorts by buying back shares of the company and thereby adding to the buying pressure for the stock.
The NASDAQ website provides short interest data for stocks listed on the NASDAQ exchange. You can search for a specific stock and view its short interest data. Here is an example of Microsoft’s short interest with the Days to Cover ration on the right hand side.
