Investors short a stock by first borrowing shares from another investor who owns them. The short seller, then, turns around and sells the shares immediately, pockets the proceeds and waits. The short seller then must buy the shares, hopefully at a lower price, and return them to the investor they borrowed from. If the stock falls, the investor makes money by buying the shares back at a lower cost than they sold them for.
You might never decide to bet against a stock yourself. But it may be useful for a fundamental analyst to know just how many people are shorting a stock they do own. There are three things to pay attention to when it comes to short interest:
- Short interest: A stock's short interest is a measurement of how many shares of a company's stock have been sold short.
Just looking at short interest doesn't tell you a whole lot. A company with more shares outstanding, or shares in investors' hands, would naturally have more short interest than a company with fewer shares outstanding. You'll want to compare short interest with another measure to get proper perspective.
- Average daily share volume: Remember volume, mentioned above? This data will be helpful again in interpreting how significant short interest is by putting short interest into perspective.
- Days to cover: Days to cover tells you how large a company's short interest really is. Days to cover is calculated by dividing a stock's short interest by its average daily volume. This statistic indicates how many days of typical trading it would take for the number of shares being shorted to trade hands.
The higher a stock's days to cover is, the more heavily shorted it is. Fortunately, all three types of shorting data described above are available at Nasdaq.com. Just enter a stock's symbol into the site, click on the name of the company, and a window will pop open. Click on the Short Interest option listed on the left-hand side of the page beneath where it says "Fundamentals."
Determining what short interest means to a fundamental analyst is bit tricky. Some fundamental analysts like to see a stock that's heavily shorted. If you're completely confident in your fundamental analysis and know what a company is worth, and believe the stock is undervalued, heavy short interest can actually be a good thing. When stocks are heavily shorted, if the company delivers solid earnings, investors who shorted the stock may scurry to buy back the stock.A rush by nervous short sellers to buy back a stock they wrongly bet against is called a short squeeze. Short squeezes can cause powerful stock rallies.
Fundamental analysts may also view a heavily shorted stock as a warning sign. After all, an investor who shorts a stock is exposed to a theoretically infinite loss, because there's no real limit to how high a stock can rise. If investors are that confident a stock is going to fall, you want to make absolutely sure you've done a complete job with your fundamental analysis.