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Using the Short Ratio to Avoid Under Performing Stocks

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.

short ratio

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.

strike price profit

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.

strike price loss

Understanding the Short Ratio

Usually, large financial websites such as Yahoo Finance, Google Finance and so forth mention the short ratio, so you don’t need to calculate it on your own. However, by knowing the short ratio, you can find out the actual number of shares that investors sold short on a particular stock.

For example, Yahoo Finance gives a short ratio for Ansys (Nasdaq: ANSS) equal to 6.23. First of all, this means that the number of days required to cover the short position is a bit more than 6. Typically, investors are looking for a short ratio between 8 and 10 days or higher because it is generally expected that a short ratio of this size is relatively difficult to cover, so the stock will go through a rally before hitting an upswing. For this reason, you may encounter short ratio as the “days-to-cover” ratio, as well.

So, if the short ratio of the stock is 6.23 and the average daily volume over a period of 30 days is 480,000 shares, it means that 2.99 million shares have been shorted. The short ratio calculated as:

Short ratio = Number of shorted shares / 30 – day average daily volume = 6.23 = x / 480,000 = 6.23 x 480,000 = 2,990,400 shares are shorted.

Why should you care about the Short Ratio?

The short ratio can be a great tool for identifying profitable investments. Take, for example, the stocks that are under consolidation. They have steady support and resistance levels, they trade within a narrow price range, and their trading volume is relatively low, without major spikes.

So if a stock under consolidation has a high short ratio, it means that investors are indecisive. The price can go up (as easy as it can go down), yet in a price range that mimics the recent highs and lows without major extremes. A high short ratio suggests that the stock is rallying, and if more people are buying the price will rise.

Another great aspect of the short ratio is that short selling does not only suggest a higher trading liquidity, but it is also a sign that institutional investors, like fund managers and equity analysts, are shorting particular stocks for their clients. Increased short selling means that the price of the stock will definitely go down in the short- or in the long-term. In both cases, however, it will have a greater upside potential.

Bear in mind that short selling is not an easy strategy and you have to understand how the market behaves to capitalize on short selling. Of course, you can use the short ratio as a means to forecast a company’s stock price and track down the extent of negative feeling with respect to the company. In general, a higher short ratio indicates that there is going to be some buying pressure on the stock, pushing it at a higher price. On the other hand, it shows that investors are not confident about the company.

Below is a table with companies that had short ratios higher than 10% in 2016. Notice that they are companies of different size and industry. Also, if you go to large financial websites, you will be able to find more information on the stocks that you are interested in.

real life example short ratio

Summing up, given the current market conditions and the volatility in the financial markets around the world, it is rather widely acknowledged that stocks with high short ratios under perform the market.

For value investors, this is a good starting point to construct a portfolio that can address a further decline in the stock prices and generate great returns through short selling. On the other hand, you have to be extra careful in stock selection to avoid rapid portfolio returns that may evaporate in the short-term.