If you’re going long on a stock, then it is wise of you to see what the short position in the stock looks like. As you know, shorts make money when a stock falls in price and longs make money when the stock price rises. When you look to invest in a company, it is wise to look at the information typically provided about the stock’s short positions.
The process of short selling is different than buying a stock. Short sellers do not own the shares they are buying. Selling short places the short seller in a contract with another party (typically the broker) to be able to buy X stock at a specific price at a future point in time. For example, if a stock is trading at $8 and I sell short, I am betting that the stock will decease in price. If the stock falls to $5 then I will close my position and thus buy the stock for $5. I will have a $3 profit.
To actually sell short you will need a margin account. If the stock’s price rises, then short will eventually be subject to a margin call. Margin calls happen when an accounts value depreciates to the point where the broker requires additional funds be deposited to maintain compliance. In these case, short sells may close out their positions to satisfy the margin call.
When a stock with a heavy amount of short interest starts moving north, then margin calls will eventually occur. If the stock’s price moves north fast, it can cause what is terms a short squeeze. The short squeeze happens because of a lack of supply and an excess demand for a stock. Part of this process is helped along by the fact that short sellers are having to buy the stock when they cover their position. Therefore, you not only have regular traders demanding the stock, but you have short sellers adding to the fire.
If you’re looking to get a sense of how strong the short interest is in a stock, I would refer you to Yahoo! Finance’s Key Statistics section. It can be found within the information presented per each stock.
Short Interest Ratio (Days to Cover) = Current short interest / Average Daily Volume
- As you see in the example above the stock has a short interest ratio of 2.10 days. Therefore, it would take over 2 days of trading, based on the stock’s average volume, to work through the shares held short.
Remember it’s not by accident that a stock has a high or low short interest. If you find yourself being drawn toward a stock with a lot of short positions, make sure that you understand why so many investors are short in the stock. A large short interest in a stock isn’t something that should automatically scare you away from an investment, but it should serve as a warning sign.