Trading and investing talk over the past two years has been dominated by short interest. And who can forget the dramatic appearance of that concept against the backdrop of the GameStop saga? The short sellers took a massive beating as the stock price skyrocketed within no time, making short interest a talking issue. Many traders, despite attention paid to it, still question if high short interest is actually a great buying opportunity or a red flag. This also raises a plethora of questions about the forthcoming performance of a stock or if high short interest can be used as an effective trading strategy.
In this article, we’ll have a very deep glance into short interest and how it affects stock performance, and what you can make use of high short interest for or have no involvement with it at all. We’ll look at the studies of the academics and actual trading data to make a better conclusion on whether a stock with very high short interest is good or bad for investors.
Solution:
You’ll be able to see a clear view of short interest by the end of this article and how it impacts stock performance. Whether or not you should use short interest as an indicator in your trading strategy will be discussed, also teaching you how to identify stocks with high short interest so you can determine in which to invest and which to avoid based on their likely future performance.
What Is Short Interest?
Before we get into the analysis, let’s quickly define short interest and its related metrics.
Short Interest is a total number of shares sold short but not yet covered or closed. In other words, it is the number of shares that investors have borrowed and sold in hopes of a fall in the stock price.
For example, if a company has 1 billion shares outstanding, with 50 million shorted, then the short interest is 5%.
The short interest ratio, or days to cover, would be an average number of days to wait until all short sellers buy back their short positions. Generally, a higher short interest ratio would indicate that it would take longer for the positions to be covered, and this often would be considered a sign of a crowded short trade.
Of course, some traders view high short interest stocks as risky before at least those short sellers start to cover their positions and cover in a hurry, which might eventually trigger a short squeeze, such as that event of GameStop. But is this really a buying opportunity or future drop in price? Let’s dissect it.
High Short Interest and Stock Performance: The Truth
It is tempting to think that heavily shorted stocks are cheap and ready to be squeezed. The burgeoning short interest implies that many investors are effectively betting against the stock, so that when the stock price spikes unexpectedly, those short sellers scramble to cover their position and drive the price higher.
But the data don’t support this hypothesis as a rule.
What the Data Shows
The working paper, titled “The Predictiveness of Short Interest,” by scholars concluded that short interest in a stock is typically related to poor subsequent performance. In other words, the stocks with higher short interest ratios generally lag later months and subsequent years.
And here comes the chart (1-year return) itself, from which the above conclusion better gets reflected:
Short Interest Decile Average 1-Year Return
Highest Short Interest -10%
2nd Highest -5%
Mid-Range +3%
Lowest Short Interest +8%
The evidence is clear cut: the stocks with higher short interests perform weaker than those with smaller short interest.
Why Do Stocks with High Short Interest Perform Poorer?
Market Sentiment: A high short interest can suggest that many investors think the stock will drop. It therefore suggests negatively heavy sentiment bearing down the price of the stock, making downward pressures stronger.
A short interest is a sign of weak fundamentals because this tends to be high when there is pessimism surrounding the company’s fundamentals, such as declining earnings, poor management, or an unsustainable business model. Short sellers may be betting against the stock because they believe it is overvalued or experiencing financial trouble.
Overcrowded Short Positions: Thus, though the price is pushed up temporarily due to a short squeeze, once most of the short sellers have been squeezed out of their short positions, the buying pressure subsides and the stock may well revert again to its downward course, especially if there is no fundamental justification for the surge in price.
Overreaction of Market Participants: High short interest creates pressure for the short sellers; this might urge them to act more violently. Thus, the price may bounce momentary but again falls down because of the insufficiency of underlying support.
Is High Short Interest an Opportunity for Short Squeeze?
In that case, high short interest of a stock proves to be just an average performer. Sometimes, though, high short interest does present an opportunity of sorts when the right circumstances for a short squeeze come into play. That is, of course, when some jolt – perfectly surprising – occurs within the stock with high short interest, causing a stampede of short sellers to scramble to buy back those shares simply to close their selling positions, thus fuelling higher prices.
While rare and unpredictable, short squeezes are pretty important events. Such stocks as GameStop and AMC are known around the world because of gigantic short squeezes, which are surely the exceptions rather than the rule.
Applying the High Short Interest Indicator to Your Trading
If you are considering that you would need to incorporate short interest as a strategy for trading, you will note that there will be risks and the volatility could appear. Here is how you may approach this:
- Identify stocks with high short interest but combine these with other indicators
A note of caution, even though a stock that has high short interest averaged lousy performance in the past: the general market conditions and a stock’s fundamentals have to be factored in. A highly shorted stock can be a good candidate for a short squeeze if some catalyst, such as great earnings or new positive news can trigger a rally.
- Pay attention to the Short Interest Ratio (Days to Cover)
The short interest ratio may give a sense of how “crowded” a short position is. A high short interest ratio-for example, over 5-would suggest that there may be a longer time before the short sellers can cover themselves, increasing the chances of the squeeze if the stock starts moving up. In any case, that doesn’t mean it will happen.3. Risk Management is Critical
In that case, it would be wise to use risk management tools should you decide to trade the stock with a high short interest. The above means, higher volatility; thus, setting stop losses, smaller position sizes, or diversifying your trades could work in terms of risk management.
- Consider Short Interest as a Contrarian Indicator
High short interest sometimes may be a reflection of the overreaction of the market or a contrarian opportunity. If you have the feeling that the market is wrong on the prospects for a certain stock, then high short interest can be worth pursuing as this may signal that a stock may be somewhat undervalued. This requires deep research into the fundamentals of a company and into the market sentiment.
Conclusion: Should You Trade Stocks with High Short Interest?
So, good or bad of high short interest in stocks is mainly determined by trading strategy as well as the risk tolerance itself. Normally, stocks with a high short interest underperforms compared to others given negative sentiment and weak fundamentals; pressure down for even further performance. Occasionally, though, high short interest sends signals that are chances for short squeeze, but that has happened rarely.
In fact, high short interest should be treated as an avenue of caution for most traders. Though interesting enough to monitor, it must never stand alone and must often be used in combination with other technical and fundamental analysis to guide a more informed trading decision.