The term short interest has long been a buzzword among traders and investors. It also came alive in 2021 when the GameStop saga left many short sellers reeling in losses, making short interest the most talked-about topic around. Indeed, while it receives major attention, many traders are still asking: does high short interest mean a good buy, or is it something that should be avoided? Is short interest related to the performance of the stock in the future? Can short interest ever become a good trading strategy?
In this article, we will delve deeper into the world of short interest concepts; explain its implications on stock performance; and explore how you can use high short interest to your advantage or avoid it altogether. We will analyze real and academic trading data in an attempt to understand whether stocks with high short interest are good or bad for investors.
At the end of this article you will get a clearer view about short interest, its influence on the stock performance, and whether you can apply it as some kind of indicator for your strategy. You learn how to identify stocks with high short interests and let yourself make an informed decision about which stocks are really worth investing into or worth avoiding by their likely future performance.
What Is Short Interest?
Let’s first define short interest and its metrics briefly as a primer before we get started in the analysis .
Short Interest is defined by how many shares outstanding have been sold short but remain unclosed or covered. In other words, it is the number of shares investors sold based on their belief that the stock will decline in price.
Example: If the firm has issued 1 billion outstanding shares and 50 million are shorted, then short interest is at 5%.
Short interest ratio, also known as days to cover, is the average number of days it would take for all short sellers to buy back (cover) their short positions. A high short interest ratio usually means it will take longer to cover the position, usually implying it’s a crowded short trade.
Stocks with high short interest may be perceived by some traders as danger, especially when those short sellers want to cover their positions in a rush so that they will not be victims of a possible short squeeze-for instance, the case of GameStop. However, does that inherently high short interest always evoke a buy opportunity or eventual future price decline? Let’s break it down.
High Short Interest and Stock Performance: The Truth
It is tempting to think of stocks with high short interest as being cheap and ready for a short squeeze. For one, as short interest goes up, a lot of investors are now betting against the stock. When these short sellers are surprised with a price increase, they will rush to cover, and drive it higher as well.
The data does not support this hypothesis as a rule.
What the Numbers Reveal
The study is titled “The Predictiveness of Short Interest” in academic terminology. Elevated short interest typically results in weak subsequent returns. In more simple terms, higher short interest ratios usually mean that stocks will have worse months and years ahead.
Here is a clearer chart:
Average 1-Year Return Over Time Decile Short Interest Highest Short Interest -10% 2nd Highest -5% Mid-Range +3% Lowest Short Interest +8%
Results are quite uniform: higher short interest is associated with worse returns compared to low short interest.
Why Do Stocks with High Short Interest Perform Poorly?
Market Sentiment: A large number of investors believing the stock price would drop gives a high short interest level a meaning. Then the negative sentiment exerts tremendous pressure on the stock price and tumbles it down.
Short Interest as an Indicator of Weak Fundamentals: High short interest typically represents negative sentiments about the company’s fundamentals, which could include declining earnings, lousy management, or indeed a business model that is unsustainable. Perhaps short sellers anticipate a deterioration in the company’s financial position or overvaluation of the stock.
Overcrowded Short Positions: A short squeeze can take the price much higher in the short run, but when most of the short sellers are covered, buying pressure subsides, and the stock tends to resume its downward path, at least until the price reaches a level that can be justified by fundamental reasons.
Overreaction by Market Players: Short interest at high levels makes short sellers feel urgent and could lead them to be more aggressive. It would push the price upwards for some time but eventually falls back without any more strength behind it.
High Short Interest: An Indicator of Short Squeeze Opportunities?
The greatest average underperformance has occurred in stocks with the highest short interest, even though high short interest sometimes creates a trade, primarily when conditions are becoming ripe for a short squeeze. A short squeeze is an event when a stock with a high short interest experiences a rapid increase forcing the short sellers to cover their position by buying up shares to drive the price upward even further.
However, short squeezes are so infrequent and therefore impossible to predict. Stocks that become famous are GameStop and AMC, as they both felt the impact of a gigantic short squeeze, which is anything but the norm.
Using the High Short Interest Indicator in Your Trading Strategy
If one needs to use short interest in their trading approach, he should know the risks and volatility possibilities. So here is how it can be done:
- Stocks with high short interest-invest with other indicators.
Those that have historically underperformed stocks with high short interest, but market conditions and fundamentals need to be taken into consideration. An excellent short squeeze candidate will be a stock with high short interest if there’s some catalyst like good earnings or new positive news to rally it. - Track the Short Interest Ratio (Days to Cover)
The short interest ratio can give you insight into how “crowded” the short position is. A high short interest ratio-over 5, for example-may indicate that it takes more time to cover for the short seller and increases the chances of a squeeze if the stock begins to move upward. However, keep in mind that this does not necessarily mean a squeeze will occur.
- Risk Management is Key
If you’re trading with high short interest stocks, then you’re likely to need to use some risk management tools. There’s probably going to be more volatility, so you’ll probably want to set stop losses, mini-position sizes, and diversify those trades to reduce risks. - Use Short Interest as a Contrarian Indicator
Sometimes, high short interest may give the impression of overreaction by the market or perhaps a contrarian opportunity. And if it feels that the market is wrong about a stock’s prospects for the future, then possibly this can be scrutinized through high short interest as undervalued. Such research requires deep digging into company fundamentals and the market sentiment.
Conclusion: Trade Stocks with High Short Interest?
Whether stocks with high short interest are to be bought or sold makes all the difference-it is largely dependent on your trading strategy and your risk tolerance. Overall, stocks with high short interest typically underperform because they often experience negative sentiment, weak fundamentals, and pressure toward the downside. At times, high short interest can work as a signal for a good entry into a short squeeze, which is a rare and unpredictable event.
To most traders, the presence of a high short interest should be viewed with caution. While it’s one interesting indicator to watch, it must never alone be the deciding factor for trading ideas. It has to be combined with other technical and fundamental analyses in making better decisions to trade.