How Short Selling on a Stock Can Inform Your Day Trading

The short interest ratio is an indicator of stock price pressure — up or down — resulting from short sell positions held in that company’s stock. If the short interest is high, then the security price is likely to go up. Likewise, if short interest is low, there will be little buying pressure in the near future.

Short selling is a way to make money if a security falls in price. In the options and futures markets, one simply agrees to sell a contract to someone else. In the stock and bond markets, short selling is a little more complicated.

The short seller borrows stock or bonds through the brokerage firm and then sells them. Ideally, the price will fall, and then the trader can buy back the stock or bonds at the lower price to repay the loan. The trader keeps the difference between the security’s selling price and its repurchasing price.

People take the short side of a position for only one reason: They think that prices are going to go down. They may want to hedge against this, or they may want to make a big profit if it happens. In the stock market in particular, monitoring the rate of short selling can give clues to investor expectations and future market direction.

The New York Stock Exchange and NASDAQ report the short interest in stocks listed with them. The data are updated monthly, as it can take a while for brokerage firms to sort out exactly how many shares have been shorted and then report that data to the exchanges.

The resulting number, the short interest ratio, tells the number of shares that have been shorted, the percentage change from the month before, the average daily trading volume in the same month, and the number of days of trading at the average volume that covering the short positions would take.

The loans that enable short selling have to be repaid. If the lender asks for the securities back or if prices go up so that the position starts to lose money, the trader is going to have to buy shares to make repayment. The harder it is to get the right number of shares in the market, the more desperate the trader will become, and the higher prices will go.

An increase in short interest shows that investors are becoming nervous about a stock. However, given that short interest is not calculated frequently, the number would probably not give a trader a lot of information about the prospects for the company itself.

This doesn’t mean short interest doesn’t carry a lot of useful information for traders. It does. If the short interest is high, then the security price is likely to go up when all the people who are short need to buy back stock. Likewise, if short interest is low, there will be little buying pressure in the near future.

High short interest, along with other bullish indicators, is a sign that prices are more likely to go up than down in the near future.

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