The short seller borrows shares from his broker and immediately sells them on the open market. He then waits, hoping for the stock price to decrease, when the short seller can profit by purchasing the shares back on the open market. Of course, in order to profit from this trade, the short seller buys these shares back at a lower price than initially paid for borrowing and returns them to his broker.
Thus, the profit of the short seller is the difference between the price received after selling the borrowed shares on the open market and the price paid when he buys the shares back in order to return them to his broker.
While waiting the short seller has a short stock position.
Schematic representation1 of short selling in two steps:
There is an interesting article written on Investopedia about When to Short a Stock which you can read by clicking on this link.
Short Interest Data
Twice a month, brokerage firms are required to report the number of shares that have been shorted in their client accounts to the appropriate regulators. This information is totalized for each stock and then released to the public.
Short interest is the total number of shares of a stock that have been sold short by investors but have not yet been covered or closed out. Stocks with a high short interest can be quite risky as an investment for two reasons:
- Because many investors believe that the stock price will fall due to the high short interest, this could result in a self fulfilling prophecy;
- Because many speculators buy stocks with a high short interest for the possible prospect of a short squeeze.
Short squeeze: when the price of a stock with a high short interest begins to rise, short sellers will often reverse their positions and therefore add to the demand by buying shares to cover their short positions, causing the share price to increase even further.
There are three key indicators that are commonly used to measure the level of short interest in a stock: the short interest (as a percentage of a stock’s total amount of shares outstanding), the short interest as a percentage of a stock’s total float and the short interest ratio. You will find a more detailed explanation below.
1. Short Interest
The short interest is calculated by dividing the total amount of shares short by the total amount of shares outstanding and is often expressed as a percentage. By also calculating the change in short interest you can even gain more insights into Mr. Market’s2 thoughts about the expected direction of the stock’s share price, as an increase in short interest means Mr. Market is more certain that the stock price will decline, and vice versa.
According to the report of Asher Curtis and Neil Farger, titled: “Does Short Selling Amplify Price Declines or Align Stocks with their Fundamental Values?“, the average short interest is 2.4%. By applying the 80/20 rule to this percentage, I have determined the average short interest range at 1.9% to 2.9%.
2. Short Interest as Percentage of the Float
The float refers to the total number of shares available for trading. Thus, the float is calculated by substracting the insider ownership and the institutional ownership from the company’s total shares outstanding.
The short interest as percentage of the float is calculated by dividing the total amount of shares short by the float. By also calculating the change in the outcome of this ratio more insights into Mr. Market’s thoughts, concerning the expected direction of the stock’s share price, will be revealed.
The outcome of this ratio will be higher than the outcome of the short interest calculated above, as the same amount of shares short are now divided by a smaller amount of shares, i.e. only those shares which are available for trading.
In regards to what I believe is the minimum share ownership percentage, owned by corporate insiders and institutions combined: I have determined this minimal combined share ownership at 5% – the maximum float is set at 95% of the total shares outstanding. Thus, the average short interest as percentage of the float is determined at (2.4% x 100 / 95 =) 2.5%. By applying the 80/20 rule to this percentage too, I have determined the average short interest range as percentage of the float at 2.0% to 3.0%.
As stated in the article mentioned above, I have determined that company’s with a small marketcap (< 100 million) must have a higher percentage share ownership of insiders and institutions combined than bigger company’s. Therefore I do not interpretet an outcome slighlty over 3% for this ratio to be really negative – for company’s with a marketcap < 100 million.
3. Short Interest Ratio
The short interest ratio is derived by dividing the total short position by the average daily trading volume, generally calculated over the last 30 trading days. The short interest ratio is also referred to as days to cover, as it is a rough estimate of how many days it would take the shorters to buy back all of their shorted shares at the stock’s average daily trading volume. Thus, the higher the short interest ratio is, the more vulnerable the stock is to a short squeeze (as it will take longer to buy back the shares necessary to close the short stock position).
After interpreting a great deal of data found on the internet, I concluded that the average short interest ratio range is 4 to 6. As an example, I found this graph3 of the NYSE short interest for the period 1996 to 2001, as shown below.
You might be asking yourself where to find the online data regarding short stock positions, short interest and days to cover. Fortunately, there are some great free resources for this information. As my stock portfolio is mainly concentrated in Canadian and American stocks, I will describe these great free resources below.
Canadian Short Stock Positions
To analyse the short stock positions in a specific Canadian stock, you can best use the Short Position Tool from Stockwatch.com. The short positions for the TSX and TSX-Venture are reported twice per month (on the 15th and on the last day of every month). Stockwatch.com receives the actual reports three days later and then updates this data on their website. You can find this data by visiting: http://www.stockwatch.com/Analytics/Shorts.aspx?action=go&symbol=TCM®ion=C. By replacing ‘TCM’ at the end of the url by the ticker symbol of the company you would like to know the short stock positions of, you will be redirected to this company’s short position report. In this case TCM redirects to the short position report of Thompson Creek Metals.
American Short Stock Positions
In order to view the short positions in all American listed companies you can go to www.shortsqueeze.com.
In addition you can visit HighShortInterest.com who provides a convenient sorted database of stocks which have a short interest of over 20 percent.
Cautious Note: Never buy or sell a stock because the short interest suggest you should. Always complete your due dilligence as a whole before you decide what to do with the specific stock on your radar.
You may also want to read...
- Mining Companies Analysis - Learn How to Invest in Mining Stocks. To execute your own mining companies analysis, I have created a lot of (sub)pages about the relevant terminology and working methods from the mining sector.
- Oil and Gas Companies Analysis - How to Invest in Energy Stocks. I created different pages about the relevant terminology and working methods from the energy sector to conduct your own analysis for oil and gas companies.
- Understanding the Stock Market - How Do Stocks Work. To help you with understanding the stock market, I have created some articles to explain how stocks work and I also reveal my own stock market analysis in this chapter.
- How to Invest in Shares - Learn How to Start Investing in Stocks. In this chapter I inform you how to invest in shares - the UndervaluedEquity.com way. I also reveal which (free) resources I use to execute my due diligence.
- How I Invest in Stocks - My Preconditions for Selecting Undervalued Stocks. In this chapter I answer the question: how do I invest in stocks? Thus, I explain which investment rules I follow whilst selecting companies for my stock portfolio.
- Stock Investment Analysis - A More Detailed Elaboration on How to Buy Stocks. When a company complies with my preconditions for selecting undervalued stocks, I will elaborate my stock investment analysis to assess the quality of it's assets, management, etc.
If my articles are helpful to you, please consider supporting my work by making a small donation...