Investing in the stock market can be like crossing a two-way street. You need to look a traffic going both directions.
In the case of the stock market, there are always buyers and sellers. Determining which group is exerting the most influence tells you whether the market is going up or down.
If there are more buyers than sellers, prices go up. If there are more sellers than buyers, prices go down.
In the unusual world of Wall Street, you can go the wrong way on either side of the street and it is perfectly legal.
One of the ways to do this is to short a stock (see below for more information on selling short). When you short a stock you sell shares you don't own at the higher price and when the stock's price drops like you hope it will, you buy the shares back at a lower price and return the shares you originally borrowed.
In most cases, I would advise long-term investors to avoid short selling, since it is purely a play on price change and very short-term by definition.
However, if you know that a large number of investors are shorting a stock (betting the price will drop), that might be useful information.
There is a way to discover what the sentiment is regarding a certain stock.
What do you do if CNN is reporting that short sellers are betting a rally that has pushed the major indexes to new highs will fizzle like other recent rallies?
What does this mean to the average stock investor? That may depend on whom you talk to because an increase in short interest can be interpreted several ways.
If traders believe stocks are over-priced and about to fall, they will short the stock and profit when the price drops. If the price does not drop, they must cover their position and buy back the stock at a higher price, which, if there are enough short sellers may drive up the price even higher.
Short Selling Defined
For more information read this article on selling short.
Other investors don't worry about short interest too much since selling short is often used by investors to hedge positions and, as a practical matter, short sellers are often wrong.
There is something you can do to monitor your individual stocks or to checkout stocks you may be considering for your portfolio.
The short-interest ratio is a tool you can use to see whether short sellers believe an individual stock is about to fall in price. The ratio is calculated by dividing short interest by average daily volume of the stock.
The ratio tells you how many days (based on average volume) will be needed to cover all the shorts if the stock price rises instead of falls.
A ratio over two indicates the stock's price may go up in the future as short sellers buy it to cover their positions. (Remember, in a short sale, the investor makes money when the stock's price falls.) The higher the ratio, the more difficult it will be to cover shorts, potentially driving up the stock's price.
A low short-interest ratio may indicate that short sellers feel the stock's price will stay flat or fall.
One place to find this ratio of individual stocks in at shortsqueeze.com. Enter the stock's symbol, and you will find a wealth of information on the shorts interest ratio and other short statistics.
Watching the short-interest ratio and the number of short sellers is one tool when evaluating stocks, but don't ignore the fundamentals for single source buy or sell tools.