
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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