Is a Low Short Interest Ratio Good?

Short interest is a direct consequence of short sales, which are governed by special rules and regulations. Short interest is an important indicator that helps you measure investor sentiment about a particular stock or the market in general. Like many financial measures, short interest must be evaluated within the broader context and can mean different things under different circumstances.

Short interest is a measure of short selling a stock, or "shorting." Assume you think that the price of Citibank stock will decline and you wish to profit from this expectation. When you enter a short sale order for Citibank stock through your broker, the brokerage company will try to locate Citibank shares held in another client's account and sell them at prevailing market prices, say $50 per share. If the stock then declines, you can buy the stock back at, say $48, deliver them to the account you borrowed them from and pocket a $2 profit per share.

Brokerages must report all short sales to the legal authorities, who keep track and publish a figure called short interest. This figure is the sum of all shares that have been borrowed to sell short but have not been replaced. The short interest ratio equals short interest, divided by the average daily volume of the stock. If, for example, 100 million shares of Citibank have been shorted and not bought back, and an average of 20 million Citibank shares change hands each day, on average, the short interest ratio equals 100,000,000 / 20,000,000, or 5.

All shares that have been shorted must be bought back eventually. In fact, most short sales are covered relatively soon, as waiting too long may result in the original owner attempting to sell the shares. When this happens, the brokerage may either try to locate other shares to borrow or force the short seller to immediately buy back the stock. The short interest ratio tells you how quickly the short sellers can, in theory, cover their short positions. Since short sellers must buy back 100 million Citibank shares and an average of 20 million shares of Citibank stock change hands each day, they need no less than five days to cover their shorts. This is a theoretical figure, however, and reality can be very different. For one thing, trading volume can drastically change on any day.

A low short interest ratio means that not many investors think the stock's price will decline. This shows optimism -- or at the very least a lack of pessimism -- by investors. However, a high short interest ratio can have a paradoxically beneficial effect on the stock as well. Should a stock with a high short interest ratio begin to advance, the short sellers may panic and begin buying the stock to cover their shorts. The lower the stock price, the more the short sellers profit; as the stock price climbs, they lose money. This panic buying by large numbers of short sellers may result in a so-called "short squeeze" and take the stock price much higher.