The short ratio is one of the metrics that traders use to strategize in the stock market. How familiar are you with this helpful metric? Have you used it to buy or sell shares? If not, this article ensures you have the correct info to bolster your investment decision-making.
Read on to find out how a good grip on the short ratio can help you enter and leave the market at the right time.
What Is Shorting?
Usually, when you invest in a stock, you expect its price to rise so that you can make a profit after selling the shares at a margin. On the other hand, when you short a stock, you borrow shares from a broker on margin, sell those shares, and purchase them when the share price falls to return to the brokerage.
Thus, you would make a profit when the share price falls.
Check out this article if you are interested in knowing more about short-selling stocks and how to do it profitably using options.
What Is a Short Ratio?
The short ratio is a mathematical indicator that traders use to check if a stock is heavily shorted in the market. In many cases, it’s also called the short interest ratio or used interchangeably with another metric called days to cover.
It is typically mentioned in terms of days because it represents the number of days it will take for short sellers to repurchase the shares they have borrowed. In other words, it is the number of days taken for the entire short interest of a stock to be covered in the open market. In fact, short Ratio is a critical financial indicator used to assess the sentiment of investors towards a particular stock, especially for the best stocks under $1, as it reveals the number of short positions relative to the average daily trading volume.
Short interest, different from the short interest ratio, is just another term for the total number of shares sold short. The short interest ratio (or short ratio) is a better indicator than the short interest because the former takes the current liquidity of the stock into account.
To calculate the short interest ratio- divide the number of shorted shares for a stock by the average daily trading volume in a specific period (usually 30 days).
Short interest ratio = (Total shares shorted) / (Average daily trading volume)
Let’s consider a company ABC that has 10 million shares sold short in the stock market by traders. The 30-day stock's average daily trading volume for ABC shares is 2 million. Then, the short interest ratio comes out to be: 10 million / 2 million = 5 (or 5 days).
Percentage of Float
Sometimes, instead of days, the short interest ratio is expressed in the form of a percentage of float. This indicator is similar to the short interest ratio, except that the denominator is the public float or the total number of shares of a company available to trade.
Thus, percentage of float = [(Total shares shorted) / (Public float or the number of shares available to trade. )] x 100
It’s clear that the percentage float, again, does not take a stock’s liquidity into account, as there is no consideration of the number of shares traded daily.
In our example above, if the total number of ABC shares available for trading is 50 million and 10 million shorted shares, the short interest as a percentage float is 20% [(10/50)*100].
How to Find a Stock’s Short Ratio
All brokers are required by financial regulatory bodies to report their short interest twice a month. This helps determine the overall short interest in every stock, which is then reported by most stock exchanges two times per month to all users.
You will also see this info of every stock on sites like Yahoo Finance and Google Finance. So, while you likely won’t have to calculate the short interest ratio for a stock on your own, you must be familiar with what it indicates for a stock. This, in turn, will let you incorporate the info into your trading strategy.
Interpreting the Short Ratio
The short interest ratio works as a snapshot of the market’s sentiments toward a stock. We saw right at the beginning that traders who short a stock expect the stock’s price to fall. Thus, if a stock’s short ratio is on the higher side, a large number of its shares have been shorted.
This could indicate a general negative sentiment in the stock market—an expectation that the stock price will move downward. However, based on other market indicators, it can also be interpreted that the stock is available at a bargain and could rally soon.
Similarly, a lower short interest ratio could indicate positive sentiment, meaning you may want to buy the share prices are likely to rise.
The trend of change in the short interest ratio can also reflect market sentiment. A short ratio trending upward can signal that investors are beginning to lose faith in the stock. In contrast, if the short interest ratio decreases over time, it may indicate an improvement in public sentiment.
What Is a Good Short Ratio
What is a “high” or a “low” short interest ratio? In the previous section, you might have noticed that we have not stated definitive interpretations for the short ratio. The short ratio is not a perfect indicator on its own but just a starting point to understand a stock market performance.
Your eventual trading strategy should consider several other factors, such as the 50-day simple moving average.
For the same reason, there is no absolute high, low, or good short interest ratio. Generally speaking, a short ratio of five days or more is considered high. In the percentage of float terms, a high value would be 10% or above. Similarly, in general terms, a low or good short ratio is anything from one to four days (or under 10% as a percentage of float).
However, knowing whether the value is good for you or not depends on how you are betting on a stock and how well the short interest ratio can help predict the stock price movement.
Limitations of the Short Ratio
There are two notable limitations of the short interest ratio. One, while it is a valuable indicator, it cannot decide your trading strategy in isolation.
News and events, overall market conditions, and other factors can impact the short ratio and a stock price movement.
Two, since brokers and exchanges are required to report short interests twice a month, the short interest ratio is usually updated on the 15th and the last day of a month. Thus, the short ratio may not always capture market changes in the interim period.
Final Thoughts
Like all market indicators, the short interest ratio is meant to guide decisions and is not a foolproof tool to be relied on blindly. Always do your own research to understand a stock’s context before investing your money.
If the above caveats are kept in mind, this information on a good short interest ratio will ensure a more fruitful engagement with the exciting world of stocks.
