“What is a high short ratio” is a question that arises in the minds of all options trades, especially beginners. Why so? Because all of them know that options traders must consider the short interest ratio while trading. However, no one knows what a high short ratio is and why they should pay attention to it.
That said, we are going to share a detailed answer to this question. We are going to explain in the simplest words what a high short ratio and much more. So, keep reading to expand your knowledge and avoid losses caused by a high short interest ratio.
Short interest ratio
Before discussing what is a high short ratio, it is important to know what is a short ratio or short interest ratio. A short interest ratio refers to how many days it would take for investors to close out their short positions in an open market. In simplest terms, the ratio tells investors how many days they would need to buy shares again and close their outstanding position. And that is why it is also known as “days to recover”.
As the name suggests, the short ratio is a mathematical formula for calculating the average number of days it would take for short-sellers to cover their short positions. You can calculate it by dividing the number of shorted shares of a company by the average daily trading volume of stocks of that company. So, the calculation of the short ratio is pretty simple as you need to know two variables. The formula is;
Short interest ratio = Short interest ÷ Average daily trading volume
- Short interest – The total number of shorted shares of a company
- Average daily trading volume – The average number of shares traded each day
Furthermore, it is not a big deal to access the data required for short ratio calculation. As per Financial Industry Regulatory Authority (FINRA) and the US stock exchange rules, brokers are required to report short positions twice a month. Additionally, Google Finance, Yahoo Finance, and other similar financial websites also provide a short interest ratio. You just need to search for a stock’s ticker to find all the information. Therefore, you don’t need to calculate it by yourself if you don’t want to. However, it is a good idea to learn about and understand it.
Suppose short-sellers short 5000 shares of a company named Umbrella and the average daily trading volume of the company is 2500. So, the short interest ratio or days to recover will be;
Short interest ratio of Umbrella = 5000 ÷ 2500 = 2 days
That means investors need just two days to recover their short positions. However, this isn’t something that remains constant over time. Why so? Because of a change in the number of shorted shares or average daily trading volume. Let’s say that the number of shorted shares of Umbrella reaches 10,000 shares. So, days to recover will reach 4.
Similarly, if the number of shorted shares remains similar but the average daily trading volume drops by half, the days to recover will be 4 days. In such cases, investors need more days to recover their short positions.
The importance of the short interest ratio
So, the short interest ratio formula gives us a number when we divide the number of shorted shares of a company by the average daily trading volume of stocks of that company. But the main question is why is this number important?
To understand the importance of days to recover, it is important to know how short-selling of stocks works.
Short-selling of stocks
Short-selling refers to a trading strategy that involves borrowing shares from a broker and immediately reselling borrowed shares hoping that the price would drop. Thus, short-sellers make a profit when the stock price drops because they can buy back shares at a lower price and return them to the broker. In other words, the difference between the original price and the price paid for repurchasing shares is the profit short-sellers earn.
Contrarily, the risk is also very high if things don’t go as planned. That means, traders will have to suffer substantial losses if the stock price rises while a short position is still open. Losses will be huge in such cases because no one knows how high prices can go. Therefore, short-sellers always prefer to buy back shares immediately to close out their short positions. So, we can conclude that a lower short interest ratio or days to recover suits short-sellers as it will take a few days to recover. Conversely, a higher short interest ratio or days to recover doesn’t suit short-sellers as it will take more days to recover.
A short squeeze
There is another point to remember here and that is the vulnerability of a stock to a short squeeze. Yes, it is possible. Suppose that short-sellers are in a rush to close out their short positions. As a result of that urgency, they may end up pushing prices higher. It is possible as history suggests that short-sellers inadvertently pushed prices higher in the past. Therefore, it is important to note that a stock is more vulnerable to a short squeeze if the days to recovery are higher.
What is a high short ratio?
After understanding the short interest ratio, it is time to discuss the answer to our main question “what is a high short ratio”.
It is a chain of events that leads to a high or low short interest ratio. The chain begins with short-sellers shorting stocks of a company. Afterward, they need to recover from their position to return borrowed shares to their brokers. And the days to recover formula tells us how many days it would take them to recover their positions. So, that number can be low, high, or in between. Now, the important point is to always watch for short ratios reaching extremes in either direction.
In fact, the short interest ratio also tells us about the market sentiment along with other indications it offers. A low days to recover ratio indicates a strong bullish sentiment in the market. It is because investors will also need fewer days to repurchase stocks at lower prices.
Conversely, a higher short interest ratio indicates more days to recover from shorted positions. It can be a dangerous situation. Firstly, traders need more days to recover and that is risky. Secondly, short-sellers may inadvertently push prices up when trying to recover from their positions. So, we can conclude that heavily shorted stocks are due for a bounce because of heavy short-selling. And short-covering rallies always push prices high as short-sellers try to recover quickly and limit their losses.
Some rules to remember
“What is a high short ratio” is a question that has no absolute answer. How high a short ratio should be considered high? Traders have different opinions about it. However, there are a few rules most experts agree on.
- A short ratio between 1 and 4 indicates a strong bullish sentiment and that doesn’t suit short-sellers.
- A short ratio above 10 tells about extreme pessimism.
- A short ratio as a % of float below 10% suggests strong bullish market sentiment.
- A short ratio as a % of float above 10% suggests strong bearish market sentiment.
- A short ratio as a % of float above 20% is too much
What does a high short ratio mean for individual traders and investors?
A short interest ratio or days to recover is a useful metric for individual traders and investors even when they don’t do short-selling. However, it is also important to keep in mind that this ratio can become outdated immediately. Because brokers are required by law to report it just twice a month. Therefore, the key is to remain vigilant.
How can you profit from it? For example, you want to buy stocks of a company with a high short ratio. It is a good idea because a higher short ratio means a high risk for shorting. Short-sellers would prefer to close out their positions immediately. This emergency pushes prices high when short-sellers repurchase stocks.
That said, you can buy stocks of that company at low and sell them for profit when prices get high. However, there is also a risk. For example, if short-sellers are correct about their predictions and prices continue to fall, what will happen? Of course, it will cause significant losses for you. That is why we keep on saying that trading is a risk arena that requires very careful consideration.