Saturday, September 12, 2009

What 'Short' Interest Says?

Shorting stocks, or betting on a decline, is considered by some to be reckless -- meddling, even. But for investors in it for the long haul, the amount of short interest is helpful because it's an indication of a company's value and its stock's possible direction.
To short a stock, a short seller must borrow shares from a broker and sell them in the market. To cover the short position, the short seller purchases the stock and returns it to the broker. Investors, who short stocks they think are overvalued, make a profit on the difference between the two prices.
The higher the short interest, the more people think the price is too high.
There are two key statistics to consider when evaluating short interest.
The first is the short ratio, which is the amount of shares shorted divided by the average daily volume of trading. That statistic shows how many days of trading it would take for the entire short interest to be covered. A high number indicates a lot of short interest or thin trading. High short ratios can lead to a so-called short squeeze, in which a large number of short sellers try to cover short positions at the same time, flooding the market with "buy" orders and artificially pushing up the price of the stock.
Sometimes short-interest ratios are about the same for an entire industry. If it's company-specific, take a closer look to understand why. In addition, short interest can rise or fall, suggesting the shares could be headed down or up.
A second short-interest metric is the short percentage of float. That is simply the short interest divided by the stock's float, or the shares outstanding minus restricted stock. Short percentage allows investors to quickly see the magnitude of a short position. A higher number means more shares have been sold short.
Comparing industry competitors with that metric allows investors to see which holdings may be overvalued. In the cell-phone industry, the short percentage shows a stark contrast in the market perception of prices.

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