Friday, August 15, 2008

Short interest ratio (SIR) and the short squeeze

The short interest ratio (SIR) for a given equity is the ratio of the total number of shares that have been shorted (short interest) to the average daily volume. The short interest ratio is also known as the days to cover since it represents how many days it would take for short sellers to cover (buy) their positions.

As a reminder, a short seller is someone that sells an equity in the hope that he can buy it back later at a lower price. In other words, he's betting for the price to go down. Every short seller will at some point have to buy the stock he shorted. This means the short sellers are a guaranteed source of demand (which can drive the price higher if the stars align properly).

The short interest for a given equity, the total number of shares that have been shorted, is computed at mid-month and end of month (it used to be just at mid-month but since September 2007, it's also available at end of month as well) by the stock exchanges and made public some time later. It can be charted as an overlay on your stock charts to see trends in short selling.

When the short interest ratio is high, it means that the short sellers could be in big trouble if the stock they have sold short goes in an uptrend. When the short sellers start covering in numbers, the famed "short squeeze" occurs and prices can really move up. The short interest ratio is a contrarian indicator since the higher it is, the more people think the underlying stock will go down (since they have shorted a lot) but it is usually used as a long trade entry decision tool. You are pretty much saying the short sellers were wrong or at least, had bad timing.

The "short squeeze" may happen when the stock is in an uptrend (stock is trading above a rising 50-day moving average for example) and the short interest ratio is relatively high. If you can figure out when the short sellers entered the trade (usually when a stock experiences a top reversal), the trade entry price can be seen as support since the short sellers will likely cover their positions once the stock goes back up to the entry price (to break even and avoid losses). Charting the monthly short interest on a stock chart can give you clues as to when the shorts sellers entered trades.

To find the short interest and short interest ratio for a given stock, you need to go to NASDAQ short interest and enter the stock of your choice in the search box. Even though it's coming from the NASDAQ stock exchange, it will give you short interest info for any stock, not just NASDAQ stocks.

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