So, if you are convinced that the stock’s price has reached its peak and is about to plummet, you can try and sell the stock short. When done correctly, shorting stocks can be quite profitable. They can even help you with hedging your losing positions.
Unfortunately, knowing the right time to exit/enter a position can be tricky, especially for beginners. Luckily, there are several indicators you can use to get the right estimate. In fact, the most reliable indicator for determining when to exit or enter a stock short is the short-interest ratio.
What Is Short Interest Ratio?
Also referred to as the days-to-cover ratio, the Short Interest ratio (SIR) is a popular mathematical indicator showing how many days short investors will take to cover their position. Basically, it’s the number of days it will take for the sellers to purchase all the borrowed stocks.
This indicator gets determined by dividing the total SI (shorted shares) by its ADTV (average daily trading volume). The SIR is popular among technical and fundamental traders who use it to identify trends. So if you want to know what is considered a high short interest ratio, please read on.
How to Use the Short-Interest Ratio
Like most mathematical indicators, the SIR helps investors do more than determine the trend. It helps them determine the right time to short a stock. The SIR can tell you how other investors feel about the stock.
What Is a High Short Interest Ratio?
Unfortunately, it doesn’t dictate the exact stock’s movement. In fact, a firm’s stock with a high short-interest ratio can continue rising, especially in a volatile market. But it can be one tool that tells you when to start shorting a stock.
For instance, if the SI of a company is 50 million while the ADVT is 5 million, then the SIR will be 10. This means that investors have 10 short interest ratio days to cover all their short positions if the price of the stock starts rising.
If the SIR is high, then the traders’ sentiment toward the firm may be souring. This means that it’s time for you to short the shares. On the other hand, if it’s trending low, then it means that the shares have a high likelihood of improving.
Difference Between a Short Interest Ratio and a Short Interest
SIR is the ratio of the SI to the ADTV. On the other hand, SI is part of SIR but not similar to the ratio. The short interest refers to the total shares short sold divided by the total outstanding shares.
The main difference between the two is that the SIR takes into account the liquidity of the shares, while SI doesn’t account for the liquidity of the given shares.
What Is the Days-To-Cover Ratio?
Generally, you usually use the SIR interchangeably with the days-to-cover ratio. And that’s because it’s similar to the SIR and measures the anticipated days it will take to cover positions on shorted shares.
So it represents the days it will take the sellers to repurchase the borrowed shares from the market. Therefore, a low days-to-cover ratio serves as a bullish indicator, while a high ratio is a bearish one.
What It Means for Individual Investors
Despite being a valuable indicator, you cannot depend on the short interest ratio alone. After all, it cannot dictate the exact movement of the stock. In fact, the price of stocks with higher ratios can continue rising.
The higher the short interest ratio value, the higher the risk of shorting a stock. Therefore, if the short interest ratio continues trending higher, the traders who shorted the shares may be planning on closing their positions to minimize losses.
So if you had shorted the stocks, you should use other indicators to confirm before closing your position.