What it means
Short interest is the total number of shares that have been sold short and not yet bought back. The theory asks what that total tells us about where prices are heading.
It is used mainly by traders and analysts who try to read market sentiment, which is the overall mood of investors. The contrarian reading, which is the better known, argues that short sellers create future buying demand.
Every short position must be closed by purchasing shares, so a large pile of open shorts represents a stock of pending purchases. When prices begin to rise, short sellers may rush to cover, adding fuel to the rally.
The opposing reading treats short sellers as sophisticated investors who do detailed research before taking a position. On that view, a rise in short interest is a warning that something may be wrong with the company, and prices tend to underperform afterwards.
Academic studies have found support for both readings in different periods and markets, which is why neither can be treated as a rule. In practice, analysts look at short interest as a percentage of the shares available to trade, and at its change over time.
A sudden jump can mean new negative information is being priced in, while a steady fall can mean the bearish case is fading. Because the figures are published with a delay, the signal is slow and best used as one input among many.
The theory has limits worth knowing. Short positions can be taken for reasons that have nothing to do with a price forecast, such as hedging a convertible bond or an arbitrage trade, which makes raw short interest noisy.
A careful reader checks the context before reading anything into the number.
In practice
Real-world examples.
Example
A portfolio manager at a mutual fund sees short interest in a retailer climb from 5% to 14% of its float in three months. Following the bearish reading, she reviews the retailer's inventory levels and decides to avoid the stock until its next results.
Example
A trader at a proprietary firm notices short interest in a small biotech company is 30% of its float, with a positive trial result due soon. Following the contrarian reading, he takes a small long position, expecting a sharp rally if the news is good. He sets a stop loss, because the trade could go wrong quickly.
Example
A strategist at an investment bank tracks short interest across an entire index. When it reaches a multi-year high, she tells clients that bearish sentiment may be stretched, and that a market bounce is more likely than a further fall.
Formula
Calculation
Short interest as a percentage of float = shares sold short / shares available to trade x 100
Suppose a company has 25,000,000 shares in public hands, and 2,000,000 of those have been sold short. The percentage is 2,000,000 / 25,000,000 = 0.08, which is 8%. A month later short sellers add another 1,000,000 shares, so the figure becomes 3,000,000 / 25,000,000 = 0.12, or 12%. The change of 4 percentage points is the kind of move that analysts using this theory pay attention to.Case study
Seen in the real world.
Quillfeather Energy is an illustrative, fictional listed company that supplies solar equipment. Short interest in its shares rose from 4% to 18% of float after a rival announced a cheaper product, and two research teams reached opposite conclusions.
One team argued that the shorts had identified a real competitive threat and sold their holdings. The other argued that the selling was overdone and that any positive surprise would force the shorts to buy back.
The company then announced a large contract, the share price jumped, and short sellers rushed to cover, lifting the price further. Six months later, however, weaker margins confirmed part of the bearish case. The illustrative lesson is that the theory can point either way, so it should not be used as a stand-alone signal.
Watch out
Common mistakes.
- Assuming high short interest always means a stock will rise because shorts must cover, when many such stocks keep falling.
- Assuming high short interest always means the company is in trouble, when some shorts are hedges or arbitrage positions.
- Trading on short interest data without noting that it is published with a delay and may no longer reflect current positions.
Questions
People also ask.
Is short interest theory a proven strategy?
No, studies have found evidence for both the bullish and bearish readings, so it works best as a sentiment indicator alongside other analysis.
How often is short interest data updated?
In many markets it is released at set intervals, such as twice a month, so you should always check the date on the figure.
What is the link to a short squeeze?
A squeeze happens when rising prices force short sellers to buy back shares quickly, and the contrarian reading of the theory is essentially a bet that this will happen.
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