Short Interest and Other Ratios

Because investors sell short so they can profit by expected price declines in the shorted securities, or they want to hedge their positions because they at least think a price decline is a good possibility, many investors look at the total short interest as a good indicator of market sentiments.

Short interest is the total number of shares that have been sold short, but not repurchased yet, to cover the short positions on an exchange. The New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and the NASDAQ release the short interest volume for their exchanges by the middle of the month, and is reported in The Wall Street Journal about a week after that.

The short-sale ratio (also, short ratio), is the total number of shares shorted, but not covered, divided by the average daily volume of all shares traded on the exchange.



                        Number of Shares Shorted, but Not Covered
Short Ratio =  ────────────────────────────────
                        Av. Daily Volume of All Shares Traded on Exchange

Note that while the numerator of the short ratio increases with short interest, the denominator, the average daily volume for that month, is not related to the short interest, and, therefore, the short ratio may actually decline when the short interest increases, which would occur when the average daily volume increases more than the short interest—and vice versa. Note, also, that, for the same reason, the short ratio does not quantify the short interest.

Real World Example—Divergence of Short Interest and the Short-Sale Ratio

On August 22, 2006, The Wall Street Journal reported that, for the month ending August 15, 2006, the short interest on the NYSE increased from the mid-July total of 9,298,283,040 shares to 9,638,209,066 shares—an increase of about 3.7%—but the short ratio actually decreased from 6.1% to 5.9% for the same month.

Some investors, however, consider a large short interest to be a bullish sign, because the short sellers will have to purchase the shorted security at some point, which will tend to increase its price. This is sometimes called the short interest theory, or the cushion theory. Technical analysts consider a short position that is twice the average daily trading volume to be a very bullish sign, and a good possibility for a short squeeze, which results when short sellers buy to cover their position, raising the stock price, which, in turn, causes more short sellers to cover their positions, thereby raising the stock price even more.

There are more specialized short-interest ratios that some investors consider. The odd-lot short-sale ratio (also, odd-lot selling indicator) is the total of odd-lot short sales divided by the total odd-lot sales.

                                                     Total Odd-Lot Short Sales
Odd-Lot Short-Sale Ratio = ─────────────────────
                                                          Total Odd-Lot Sales

This supposed prognosticator is based on the odd-lot theory, which is based on the supposition that people who buy and sell odd lots (less than 100 shares or a round lot) are novice investors, and are acting in direct opposition to true market conditions. Thus, when odd-lot selling is high, then the market has bottomed out, and it's time to buy, and vice versa. There is no real evidence that the odd-lot theory is true, but even if it is, it may be because investors believe that it is true, and act accordingly.

The member short-sale ratio, using similar, specious reasoning, is supposed to be the true market indicator, and there may be a grain of truth to this. After all, if anyone would know the market, it would be the members of the NYSE who—specialists, floor traders, and off-the-floor traders—specialize in the particular securities that they sell short. The member short-sale ratio is the total shares sold short in the accounts of the NYSE members in 1 week divided by the total short sales outstanding in the same week.



                                             Total Shares Shorted by NYSE Members in 1 Week
Member Short-Sale Ratio = ───────────────────────────────
                                                  Total Short Sales Outstanding in Same Week


The member short-sale ratio is published weekly in The Wall Street Journal and Barron's.

The specialist's short-sale ratio is computed in the same way as the member short-sale ratio, but only includes the accounts of the specialists on the NYSE.


                                               Total Shares Shorted by NYSE Specialists in 1 Week
Specialist Short-Sale Ratio = ────────────────────────────────
                                                     Total Short Sales Outstanding in Same Week

Some short sales are made to provide an orderly market in the securities assigned to the specialist—one of their duties—but many investors, especially technical investors, use this as a prognosticator of the markets.

HOW SHORT SELLING WORKS?

The process of stocks short selling consists of the following: The investor borrows shares of the stock they are going to short from his broker. This step is accomplished using "cash on deposit" at brokerage firm that can be used as collateral. So when an investor borrows stock, they're promising to give back the stock at a future point in time. The stock you borrowed is then sold at the market, and the cash from that transaction is paid in your brokerage account. You (investor) then wait for a decline in price, if there is any, and after the price goes form 15$ to 10$, you close a position by buying back the shares. This is what is called covering a short position. The investor returns the borrowed shares back to their broker or lender.

EXAMPLE OF HOW IT WORKS:

Let's say that you believe that ABC Company Inc. stock is due to fall, you then calls your broker to sell short 1000 shares of the company. Also, let's assume that your trade is immediately executed, to sell short 1000 shares of Company Inc. at $30.00 per share. You will receive a cash inflow of $30,000 from this transaction.
 

In four weeks later, the price has indeed dropped, and you are able to buy back the shares (also known as covering a short position) for $20.00 per share. In this transaction, you will spend $20,000 to buy shares that you need to cover your position. Your profit on the trade will be $10,000 ($30,000 minus $20,000). If stocks had risen to $35.00 during the time position was opened, then he would have a loss of $5,000 (1000 shares x $5.00/share).

RISK OF SHORT SELLING STOCKS:

Short seller is still trying to do the same thing a regular investor is, and that is to buy low and sell high. But the short seller is trying to do this in reverse order. He is trying to first sell high and then buy low. The short sales strategy, which is the opposite of entering a long position, is a risky one for a several reasons. These include the potential for a margin call, and theoretically unlimited losses if stock price rise, since the price of a stock cannot fall below $0 per share, the upper limit for profit is the total value of the stock sold short.

OTHER IMPORTANT THINGS TO KNOW EVEN IF YOU DO NOT SHORT SELL STOCKS:

Short interest is a measure of the total share volume that is currently short the stock. When a person short sells, the order must be identified as a short sale and these statistics are kept for each stock by the exchange. Short interest can be a source of demand if buyers become enthusiastic for the stock and price rises prompting some short sellers to reduce risk by buying back stock to replace and closing the short position.

A high short interest ratio is considered bullish while a low ratio is considered bearish. A ratio of 2 is considered 2 days potential buying power. In some future posts, when I'll write more about investment strategies, and what does work and what don't, you will se that actually, low short interest ration is a bullish sign!!! But more about that later.

The short interest ratio is called a contrary opinion indicator because an increase in short selling is an indication of a strong potential demand element as short sellers are likely to close positions quickly if the market price proves them wrong.

Odd lot short sales has been considered a measure of uninformed investors and was used by investors to give evidence of market bottoms as late comers to the market were considered uninformed. Now it's not widely used.

Specialists short sales are also available as a data source for measuring short selling. This is considered the smart money. Often investors watch the ratio of specialists short sales to total number of short sales to give an indication if the smart money is bullish or bearish. A short sell can be used as part of a bullish strategy as so can skew the basis for interpreting the ratio.

That's all for today.