Fundamental Analysis Techniques
Short Interest
LEAVE IT to Wall Street to figure out a way to profit from a falling stock. It's called "selling short" and it's becoming increasingly popular among individual investors. It works like this: Say an investor analyzes Intel and decides that all signs point to a decline in the stock price rather than an increase. Intel is trading at $60 a share, so the investor borrows shares of the stock at that price and immediately sells them. After the stock falls to maybe $40 a share, he buys it back on the open market to repay his debt. But since the price is lower, he pockets the difference -- in this case $20 a share. (Of course, if the price goes up from his original price, the investor loses big time.)
There are entire companies devoted to selling stocks short and they make it their job to seek out companies that are in trouble. They pore over financial statements looking for weaknesses. But sometimes they merely think a company is too highly priced for its own good.
Happily, the stock exchanges track "short interest" in a stock and report it each month so other investors can see what the short-sellers are up to. We track the short-interest ratio (short interest/average daily volume of the stock) on our Investor Snapshots, and it is always worth a look.
A high (or rising) level of short interest means that many people think the stock will go down, which should always be treated as a red flag. Your best course is to check the current research and news reports to see what analysts are thinking. But high short interest doesn't necessarily mean you should avoid the stock. After all, short sellers are very often wrong.
The short-interest ratio tells you how many days -- given the stock's average trading volume -- it would take short sellers to cover their positions (i.e. buy stock) if good news sent the price higher and ruined their negative bets. The higher the ratio, the longer they would have to buy -- a phenomenon known as a "short squeeze" -- and that can actually buoy a stock. Some people bet on a short squeeze, which is just as risky as shorting the stock in the first place. Our advice is this: Use the short-interest ratio as a barometer for market sentiment only -- particularly when it comes to volatile growth stocks. When it comes to gambling, you're better off in Vegas.
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