In investment analysis and portfolio management, short ratio is a widely-used tool, which indicates the number of shares that investors sell short over the average daily volume of the stock on the basis of 1 or 3 months. As a strategy of active investment management, the short ratio can be interpreted in various ways, but basically, it provides an indication of the future performance of the stock.
How Short Selling Works
Short selling is a sophisticated strategy, mostly implemented by experienced investors. Their goal is to leverage the downside risk of a long position by anticipating a drop in the price. Therefore, successful short selling is mostly used in a bearish market with a downside potential rather than in a bullish market with an upside potential.
Usually, investors that use short ratio are not so optimistic about the future trend of the market. So, they short their position by buying a stock at a given price, anticipating that the price of the stock will drop lower than the strike price (the price that they short the stock). So. Instead of the classic mantra ‘buy low, sell high”, short sellers sell high and buy low to resell higher. The best part of short selling is that the stock traded are not owed by the investor, but they are borrowed.
Let’s look at an example.
Assuming that you hold 5,000 shares of Ansys (Nasdaq: ANSS) that currently trade at $108.36. Rumor has it that the stock will decline over the next couple of days due to a drop in the company’s total revenues by 3%. So, you decide to enter a short-sale contract by borrowing 3,000 shares of your broker and selling them in the open market for a total of 3,000 x $108.36 = $325,080.
Indeed, within a week, the stock price drops to $102.35. You then decide to exercise your short sale, and you sell 3,000 shares at $102.35 for a total of 3,000 x $102.35 = $307,050. You return the 3,000 shares to your broker and you make a profit of $325,080 – $307,050 = $18,030 minus borrowing fees and broker commission.
This would be how you close the position if your anticipation of a price decline comes true. On the contrary, if the stock price rose to $112.47, you would return the 3,000 shares to your broker for a higher price that you bought them. In that case, you would incur a loss of (3,000 x $108.36) – (3,000 x $112.47) = -12,330 minus the borrowing fees and broker commission. [click to continue…]