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A female asian money managerShort interest measures how many shares of a specific stock are the object of investors’ negative outlook. These “short shares” have been borrowed by investors to sell and have not yet been repurchased to close out the position. It can be expressed as either an absolute value (the number of shares) or a percentage relative to the company’s total amount of outstanding stock. For many analysts, it is also a crucial part of tracking the market. Before starting to short stocks, consult with a financial advisor.

Shorting Explained

Short selling tends to get a bad reputation, mostly among amateurs who know just enough about the stock market to misunderstand it. In part this is because short sellers do tend to get themselves in trouble. Unlike buying long positions, shorting comes with the risk of unexpected losses (you can lose more than you initially put in). This can lead to leverage, debt and potential market instability if taken too far.

In addition, though, this is because short selling simply feels wrong to some investors. When you short a stock, you profit if the share price goes down. To many people this feels like rooting for the company’s failure. It comes across as ghoulish or rapacious. But such an interpretation is incomplete at best.

In a nutshell, the process of shorting a stock goes like this:

  • Identify a stock that you believe will decrease in value;
  • Borrow shares of that stock from a third party (often a broker who buys them for the purpose of loaning them to you);
  • Sell those borrowed shares for the stock’s current price, which is called shorting the market;
  • Wait until the stock hits your desired value (ideally);
  • Buy shares of the stock at this new price;
  • Give those shares to the third party that you borrowed the original shares from.

Buying back the shares of stock is called covering. When you return them, you have formally closed the position.

So, for example, shorting ABC Corp. might look like this:

  • Borrow 100 shares of ABC stock from a third party;
  • Sell those shares for $10 per share, netting you $1,000;
  • Wait until ABC Corp. stock declines in value;
  • Buy 100 shares of ABC stock at $8 per share, costing you $800;
  • Return those 100 shares to the third party.
  • You get to keep $200 as profit ($1,000 minus $200), minus fees and transaction costs.

The Risks of Short Interest

"RISK" spelled out in wooden blocksSince you sold the shares of stock for more than it cost you to buy them back, you will make a profit. However, shorting is much more risky than taking a long position. For one thing, with a long position you invest your money up front. To buy $1,000 of ABC Corp. stock you need to spend that money on purchase. There’s no leverage or debt inherent to the transaction, so you can’t lose more than what you’ve already put in. With shorting, if the investment goes poorly you will not know your losses until after closing out the position. Since you don’t put money in up front you can’t know how much you stand to lose on the back end.

For another thing, short sales come with the potential for unlimited losses. A long position can’t go lower than zero. Even if you borrow the money with which to invest, your maximum exposure is the money you’ve already put in. With short selling, there’s no theoretical limit to how high a stock’s price can rise. There is no limit on potential exposure if an investment goes very badly. For investors who don’t properly structure their trading with stop-loss orders this can mean high losses and even debt.

So, given the risks, why does the market prize short selling so much? Setting aside the money to be made – and you really can make a lot of money with very little up front capital – short sales play a critical role in price signaling.

The Importance of Short Interest

When investors short a stock, they are telling the market that they believe the value of this stock will go down. This can be due to any number of factors. The investor may not believe that the company’s newest product will succeed, for example. They may not like changes to the leadership team. Or they may simply believe that the stock has gotten overpriced relative to the company’s inherent value. Whatever their specific reason, investors are sending a signal: We expect this price to fall.

When only one investor does this it may mean nothing. That’s where short interest comes in. Short interest signals how much the market overall feels like this stock is likely to fall. It indicates the number of shares that have currently been borrowed for short sales and which have not yet been repurchased for return. This means that it measures how much current and active interest there is in the price of this particular stock falling. (Short interest measures only shares not yet covered because, once an investor repurchases the shares, they are indicating that they no longer expect prices to decline.)

As noted above, you can express short interest either through the raw number of shares or as the percentage of a firm’s overall shares. For example, a 5% short interest would mean that 5% of a firm’s total shares are currently held in short sales.

Short interest is both a useful and a crude measurement. When a stock’s short interest rises, it indicates that something is happening. It tells investors that a larger segment of the market thinks that this stock is overvalued and poised for a fall. What it does not tell you is why.

For example, short interest does not tell you if one massive investor has shorted the company’s stock or if a large number of smaller ones have done so. It doesn’t tell you if investors think this specific company is overvalued or if that sentiment extends to the market at large. It doesn’t tell you if investors think the company is objectively weak, or simply overpriced relative to its true value. It doesn’t tell you why investors might think the company is weak or overvalued.

What short interest tells you is that there is something here worth looking at. The higher a company’s short interest, the more it signals that investors see something. It tells you and other investors that they should look for whatever is going on before investing.

When short interest rises across multiple companies in an industry, or across multiple industries in a market, this signals that something bigger is going on. It indicates that investors have begun losing confidence in the market at large and may even warn of a coming recession. Or it could simply indicate a market correction, which happens even during periods of healthy investment.

The Bottom Line

Investor watches a security plungeShort interest measures the number of shares that have been short sold in a company’s stock. It is a very important indicator of how the market views this stock overall, both in the long and the short run. And the core lesson of short interest is this: Price declines are good. They are essential to a healthy stock market. When a company’s business model gets weaker, its share price should go down. When investors put too much capital into the market, some of it should go back out. This process prevents asset inflation and helps to keep stock prices relevant to the actual value generated by the underlying businesses. Short interest is a critical indicator to seeing when and how those declines will happen.

Tips on Investing

  • Shorting the market is a risky move. It can pay off big, especially in an over-valued environment, but the losses are no joke. The best way to consider that kind of investment is with sound financial planning, something that is best pursued with a financial advisor. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial professional in your area to talk risk, reward and how to build the right portfolio for you. If you’re ready, get started now.
  • If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your holdings with our capital gains tax calculator.

Photo credit: ©iStock.com/Laurence Dutton, ©iStock.com/gustavofrazao, ©iStock.com/Gearstd

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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