The short ratio is a widely-used tool by short selling hedge funds and other portfolio managers in the stock market. The short ratio 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.
Short selling was propelled into the limelight in 2021 with the Gamestop short squeeze that happened in the market; it was because of Gamestop’s high short ratio that the squeeze was so violent (on the upside).
In this post we will talk about the basics of short selling, which is critical to understanding the short ratio and why short squeezes are possible. Editor’s Note: This is a guest contribution by Christina Pomoni.
While the short ratio can be helpful in finding potential short squeezes in the future, it can also be a great warning sign to deter investors from making a money losing long term investment.
Oftentimes fund managers will go short a stock because of a fundamental reason, and so a high short ratio should indicate to an investor that further fundamental analysis is required to understand why Wall Street is so bearish on the stock.
How Short Selling Works
Short selling is a sophisticated strategy, mostly implemented by investors with a high risk appetite and strong conviction on their bearish ideas.
The goal of a short seller 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, though there have been plenty of cases of successful short selling amidst great bull markets.
The short ratio is great indicator at measuring how bearish that Wall Street is on a stock. Because the short ratio is calculated by using the number of shorted shares in the market, it is telling us how other investors/traders are betting on the stock, by putting their money where their mouth is.
A short seller believes that the price of a particular stock will go down. 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).
Let’s look at an example.
Say you want to short a stock trading at $108.36. 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.
Let’s say that within a week, the stock price drops to $102.35. You then decide to close 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.
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.
Let’s say you had a stock with a short ratio of 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)
If we know that the short ratio is 6.23, we can infer how many shares are shorted by calculated the following:
6.23 = x / 480,000
6.23 * 480,000 = x
x = 2,990,400 shares are shorted.
How a Short Squeeze Works
Notice how in the short selling example, the investor was required to borrow the shares in order to make a bet on the downside of the stock.
Borrowing shares from a broker is also called buying “on margin”.
When you borrow from a broker on margin, you have to pay an interest fee on the borrowed amount, just like you would if borrowing money for any other use.
Like with other borrowing, buying on margin also means needing to put collateral on the amount you borrowed.
This can become problematic for a trader on margin if the trade goes against him.
This is because, since brokers require collateral on a margin position, that amount should be fulfilled throughout the duration of the trade. So in other words, the more money that is being borrowed by the trader, the more collateral they need to put up.
Now remember, that the short seller is borrowing the shares to bet on selling them at a lower price in the future.
If the stock does not go down like the short seller anticipates but instead goes higher, that cost of borrowing becomes increasingly higher due to the shares being more expensive. Since the brokers require a certain amount of collateral on the borrowing, the trader will need to put more money down as collateral in order to satisfy the new requirement.
This is commonly called the dreaded “margin call”.
As a stock moves higher, the short sellers need to post more collateral on their positions; their brokers will call those short sellers on margin (which is all of them), demanding more collateral.
If the trader cannot come up with the additional collateral, their short position will be closed, often at a loss to the trader.
As a stock continues to move higher, more and more short sellers receive margin calls from their brokers. If they can’t cover these margin calls, they are forced to close their short positions, which pushes the share price even higher as less traders are short the stock.
This can cascade like an avalanche, where the more short sellers that are “squeezed” and can’t cover their margin calls, the more margin calls that are required, and this continues to build on itself.
This rapid succession of squeezed short sellers can cause the stock to explode higher, like we saw with Gamestop, AMC, and other companies which were targeted as short squeeze candidates by retail investors on Reddit.
An educated investor can look at the short ratio to identify stocks with lots of short sellers currently betting against it; these can be prime candidates for future short squeezes.
At the same time, an investor can look at changes in the short ratio over time to see the sentiment of Wall Street changing on a stock in real-time.
Why should you care about the Short Ratio?
Like mentioned, the short ratio can be a great tool for identifying potential future short squeezes. This can be particularly true for companies that are unfairly beaten down by the Street, when a company’s fundamentals are actually in a much healthier position than is perceived.
On the technical trading side, stocks under consolidation can provide an opportunity for short term profit. They have steady support and resistance levels, may trade within a narrow price range, and their trading volume is relatively low, without major spikes. This could signal a stock whose price looks indecisive, and could break to a noticeable trend.
Another great aspect of the short ratio is it can suggest higher trading liquidity. Those traders with strategies which rely on liquidity, particularly on smaller size stocks, could find opportunities within those stocks with higher short ratios due to the ability to quickly enter and exit the trade without liquidity constraints.
And then of course, the short ratio can be used to find the stocks that Wall Street is already bearish about and then simply piling on and riding that trend. Oftentimes, it’s the worst performing businesses which come with high short ratios, and their dire financial situations can be so apparent that shorting the stock with other smart traders can seem like shooting fish in a barrel.
However, please keep in mind that short selling is not an easy strategy and you have to understand how the market behaves to capitalize on short selling.
Because of the margin requirements, shorting a stock is an inherently short term strategy. The longer that a short position is kept open, the more in interest you’ll have to pay to your broker to keep your trade on margin.
This alone should keep many prudent investors away from a strategy like short selling, as market timing has proven to be such an impossible task.
Whatever you do, please don’t short a stock solely because you think its price is overvalued.
Shorting a great company simply because you think its stock is expensive is a sure way to destroy your wealth, because for one:
“The markets can remain irrational longer than you can remain solvent.” (a quote from the legendary economist John Maynard Keynes).
And secondly, some great companies eventually grow into their higher valuations, and some companies continue to trade at high valuations for years or even decades. That’s a long time to burn even the most disciplined short seller, especially when you consider that margin calls can eventually bleed you dry even if you are eventually right about the stock eventually falling from its overvaluation.
If there’s one secret to success in the stock market it’s compound interest, and by executing short sell trades you are inherently betting against compound interest.
They say that the stock market is a great place to invest because the potential upside is unlimited while the potential downside is capped (to -100% of your money).
In the case of short selling, you flip that paradigm—where the highest potential upside is only 100% and the potential downside is unlimited.
That’s not a great place to be in. You might be able to get lucky on some trades over the short term, but as a sustainable strategy, betting against the success of business and the power of incremental increases through compound interest is not likely to be a winning bet.
Using the Short Ratio as a Value Investor
As previously alluded to, where the short ratio could be a great asset to the long term investor is for those who buy deep value stocks.
As the Wall Street Bets community on Reddit showed explicitly through their crowding into long trades into Gamestop and AMC, a heavy short selling presence can serve like a loading spring just waiting for a catalyst to the upside.
It could be something as unpredictable as a mob which drove retail investors into stocks like Gamestop and AMC; the catalyst could also be something as basic as a company performing slightly better than particularly bearish expectations.
Just because a stock looks like it’s heading for bankruptcy doesn’t always mean it is, and for the right deep value investor with the stomach for volatility and a severe case of contrarian thinking, then the short ratio can be a great place to start a search for deeply undervalued stocks.
Remember that with deep value investing, a largely diversified portfolio with at least 50-100 stocks, and a short term holding period with active rebalancing has historically been the best application of that kind of an investing strategy.
Edited and updated by Andrew Sather – 8/24/21