Short interest can reflect general market sentiment toward a stock by indicating the number of shares sold short that remain outstanding. When measured it can be a useful but imperfect indicator of bullishness or bearishness toward a stock.

To understand short interest, it helps to first have a grasp on how short selling works.

Short selling explained

When shorting a stock, an investor borrows shares of stock and then sells them to buyers willing to pay the market price. Eventually, the investor must buy the shares back in order to return them to the lender. If the price drops — the target outcome — the investor will make a profit because they bought the shares for less than the buyers purchased them for.

However, if the price rises, the investor will lose money. That’s why short selling is considered speculation. Short selling comes with significant risk as the investor may end up paying more to buy back the shares than what they received from the original sale. This is what can happen if there is what’s called a “short squeeze.”

What is a short squeeze?

A short squeeze begins when the price of a stock unexpectedly increases, gains momentum and a significant number of short sellers exit their positions to try and cut losses. This can create a situation in which more shorts have to cover, sending the stock soaring even further in a vicious cycle. Short squeezes sometimes can happen with little notice. Unexpected good news can set up a stock price rally, creating a short squeeze in a heavily shorted stock. If this happens, short sellers must be prepared to make very quick decisions to get out. As you can imagine, this is a dangerous situation for short sellers. And, some contrarian investors may buy stocks with heavy short interest to exploit the potential for a short squeeze.

What is short interest?

Short interest is determined by the number of shares sold short divided by the stock’s float (or number of shares outstanding). For example, if 100 million Apple shares are outstanding and 10 million Apple shares are shorted, we can say the short interest on Apple is 10 percent.

Traders often sell a security short if they anticipate that the price will decline. An increase in short interest can signal that investors have become more bearish, while a decrease in short interest generally signals they have become more bullish. Sometimes these figures are distorted when traders are forced to buy to cover short positions. This can happen when the stock price goes up or there is news which traders believe will drive the stock price up.

How investors use short interest data

Experienced investors and traders use short interest data to help make investment decisions. If short interest on a particular stock is rising, it’s often a sign that investors are more bearish on the stock. In other words, a sizable increase in short interest may be a sign that investors are getting ready to sell, and it may be time to liquidate a long position. However, if short interest is falling on a security, that could mean investors are becoming more bullish. In addition, a decrease in short interest could mean that traders are getting out of their bearish positions and heading to the sidelines.

What is a short interest ratio?

The short interest ratio compares the number of shorted shares of a stock to the stock’s average trading volume. This ratio is used to estimate how many days it would take for all of a stock’s shares that are sold short to be covered or repurchased in the market. The higher the ratio, the more trading volume is required to cover the position.

Traders often use the ratio to determine whether it may take too long for a stock’s shorted shares to be covered. In this scenario, the trader may be hesitant to sell a stock short. Traders may also use the ratio to determine whether a stock has been oversold. In this case, the trader may be more inclined to sell a stock short.

What are the limitations to using short interest?

Short interest data is a useful indicator of market sentiment, but it’s not perfect. For example, the information related to the total number of shares that are sold short for a particular stock may lag, and may not be entirely accurate. Depending on when the data is posted, short interest numbers can fail to account for unexpected market conditions and can vary depending on the source.

The short interest ratio is not a perfect metric, either. For example, it doesn’t account for the possibility that some of the shorted shares may be covered by a stock’s rising price. Traders should consider using additional data to determine whether it’s a good time to sell a stock short. For example, rising interest rates usually have a negative impact on the price-to-earnings ratio, so even with strong earnings, the stock price may go down.

Bottom line

Short interest can help investors gauge the market’s overall sentiment toward a stock. It’s one of many tools that can help investors determine if they should buy or sell a security.