To fully understand short ratio stock, let’s begin by looking at shorting. In a nutshell, it’s all about borrowing stock shares and quickly reselling. The expectation is that the price drops thereafter, allowing investors to buy back at a lower price.
Going back to our main topic, short ratio is also called days to cover. The latter is a reference to the average number of days short-sellers can cover their positions.
How is Short Ratio Calculated in Stock Trading?
The calculation of the short ratio is pretty straightforward. All that you’ll need to do is divide the shorted shares number by the average daily volume. Meanwhile, the resulting number is the number of days traders can close their short positions.
The higher the ratio, the greater the possibility of a short squeeze. And in case you’re not familiar, a short squeeze is a sharp price increase that leads to closing positions of those who sold their shares. A perfect example of this is the case of GameStop in 2021.
What is a High Short Ratio and Its Implications for Investors?
As we talk about what is short ratio, let’s also briefly touch on one of the potential outcomes.
A high short ration means that most investors are bearish on the performance of a stock. Therefore, it can be a bad thing, primarily because it shows bearish sentiments. It means that investors are expecting the price to drop.
However, there’s always a way to find light in such an unfortunate situation. In the case of a high short ratio, this could be in the form of buying. As the prices fall, it can be the perfect time to buy or accumulate.
Meanwhile, it’s also crucial to remember that it’s quite a vague concept. There’s no exact number that identifies the short ratio to be high or low.
Short Ratio Stocks: Pros and Cons of Investing in Them
Among others, one benefit of short ratio stocks is you can use them as a market sentiment indicator before getting exposure.
In addition, this can also be a chance to hedge your position against a risk. Consequently, it can be an effective way to manage your risks. When done right, it can make trades more profitable.
Meanwhile, it also has its share of shortcomings. For instance, it relies solely on stock market reports. Hence, it can result in a misrepresentation.
Nonetheless, the biggest drawback is perhaps that it’s lagging. Most reports are only once a month, so the number may not be timely.
Using Short Ratio to Predict Market Trends: A Beginner’s Guide
As a beginner, you might worry that calculating short interest is difficult even if the formula is simple. Luckily, you don’t need to do so. Most stock exchanges will track such and report it once a month, making things easier.
To predict the market trend, all you need to do is determine whether the short interest ratio is high or low. In the case of high shorted stocks, there’s a higher probability of a bearish market. Meanwhile, the market trend can be bullish when the short ratio is low.
Tips for Short Ratio Trading
More than defining what is the short ratio, this post will also give you valuable tips. Below are some things to keep in mind:
- Use Other Indicators: With most exchanges reporting the short ratio only once a month, it can quickly become obsolete. Looking at other indicators can make your trades more relevant.
- Make it a Short-Term Strategy: As it’s in the name, short ratio trading is the best only for the short-term. The longer the position is open, the less profitable it can be.
- Stay Updated: Stock market reports are useful, but they’re not the only thing you need. Since they can be outdated, you should know what going on in the market to make smarter trading decisions.