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What Is a High Short Interest Ratio & the Potential for a Sizable Short Squeeze?

Original post by Jonathan Langsdorf of Demand Media

A short squeeze can turn a losing stock into a short-term winner.

A short squeeze is a rare stock market event that allows traders to earn quick profits from a rapidly rising share price. The squeeze occurs with a stock on which traders have bet a large amount of money to fall in price. The short interest ratio is the first indicator of a pending short squeeze.

Short Interest

A stock market trader sells shares in a company short to profit from a falling stock price. To sell the shares, the trader first borrows them from his broker, then enters the trade as a short sale order. The trader must buy back the sold short shares to close a short sale trade to realize a profit or loss. The number of shares of a particular stock that are currently sold short is referred to as the short interest in the stock. The New York Stock Exchange and the Nasdaq track the amount of stock sold short, and they provide regular reports of the outstanding short interest for each stock.

Short Interest Ratio

The short interest ratio calculates the short interest for a stock in relation to the total number of shares the company has trading in the market. The total number of a company's shares held by investors and available for stock market trading is called the float. The current short interest dividend by the float gives the short interest ratio. For example, if a stock has a float of 60 million shares and 6 million are currently sold short, the short interest ratio of the stock is 10 percent.

Buying Demand

When there are more buyers than sellers in the market, the price rises until the two sides balance. An excess of sellers pushes down a stock price until enough buyers come in to balance the sellers. Short sellers, by their actions of selling shares short help push down share price. However, short interest becomes future buying demand. Typically, the buy orders from short sellers to cover their positions are spread through the stock market sessions. If downward pressure continues on a stock, the shorts will get out with profits intact.

The Squeeze is On

A short squeeze occurs when a stock with a high level of short interest shows signs of going up. If enough of the traders who shorted the stock decide to close their positions with buy orders, the buying pressure can further push up the stock price. As the price moves higher, more short traders try to buy back shares, putting more upward pressure on the share price. A stock with a high short interest ratio could end up with a lot of short sellers trying to buy, and no sellers on the other side. The owners of the shares want to keep their shares as the price keeps rising. This short squeeze action may result in a very rapid price increase. For example, the October 2008, the short squeeze of Volkswagen stock on the German market saw the share price increase from around 300 euros per share to over 1,000 euros in a single day.

                   

References

About the Author

Jonathan Langsdorf has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Langsdorf has a bachelor's degree in mathematics from the U.S. Air Force Academy.

Photo Credits

  • Comstock/Comstock/Getty Images

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