Short-Interest Theory

Short interest is a measure of the number of stocks sold short in the market over time, indicating future market demand. Technical analysts use the information about short interest as a sign of weakness or strength in the market. For instance, when stocks are sold short, it is with the anticipation that their prices will go lower so that they can then be bought back at lower prices. Analysts monitor short-interest figures, and they contend that short-interest positions that are large are bullish indicators. The reason is that when large short positions are open, short sellers eventually have to buy back the stocks, which drives the prices up. Small amounts of short interest are considered of no consequence to future market activity. The short-interest theory may not be a reliable indicator of future market sentiment because the number of stocks sold short is a small percentage of the shares outstanding on the NYSE. In addition, short selling also may take place for tax purposes rather than in anticipation of a lower price.

The short-interest ratio is the short interest divided by the average daily volume, which is used to determine the direction of the market. The short-interest ratio shows the relationship of short sales to the total number of shares traded. The short-interest ratio for the NYSE is calculated by dividing the short interest of the NYSE by the average daily volume on the NYSE for the same period. This ratio also can be calculated for other markets and for individual stocks.

Short-interest ratio = short interest/average daily trading volume

Short-interest figures are released in the middle of every month by each of the exchanges. If the short interest on the NYSE is 22 million for one month and the average daily trading volume for the NYSE in the same month is 20 million shares, the short-interest ratio for that month is 1.1 (22 million / 20 million).

The ratio is greater than 1 when the average daily volume is less than the short interest. Ashort-interest ratio of between 1 and 1.6 is considered neutral. Technical analysts regard a ratio greater than 1.6 to be a bullish signal because short sellers will have to cover their positions and buy back the stocks. Aratio of less than 1 is considered bearish. This indicator invites some ambiguity because technical analysts believe that with a large short-interest ratio, short sellers will have to buy back the stocks eventually, which sends stock prices up. However, short sellers have shorted the stocks because they think that the stocks are overvalued and that their prices will decline.

Although this indicator is popular among technical analysts, it too is not infallible in predicting market direction, and no research appears to support the use of this technique as an accurate indicator of price movements.

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