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The short interest ratio measures what proportion of trading in a company’s stock involves shorting. Shorting is where people are buying and selling shares with the intention of making profit from the stock price falling rather than rising. The short interest ratio is something of an indicator of whether the market as a whole is optimistic or pessimistic about a stock’s future movements. However, it’s only one measure and should not be taken in isolation.
Most people outside of the financial worlds think of the stock market in terms of buying a stock and then hoping to sell it later on for a higher price. Shorting is a way that investors, usually corporate investors rather than individuals, can reverse this process. It means buying and selling in a way that makes money if a stock price falls.
The usual method for shorting a stock effectively involves borrowing stock from somebody for a fixed period and immediately selling it to someone else. When the loan period is over, the person shorting will buy back the same number of shares and give them back to the lender. If all has gone to plan, the price will have dropped in the meantime, meaning the shorter is able to buy the stock for less than they originally sold it for and thus keeping the remaining money as profit.
The short interest ratio, otherwise known as the short ratio, is based on how many shares in a company are on loan for shorting purposes at any particular time. The number of shares being shorted, divided by the total number of shares traded each day, gives the short interest ratio, usually a single digit number. Using a ratio rather than simply measuring the amount of shorting helps go some way to distinguishing between the type of shorting that is simple down to ordinary day-to-day trading, and the type of shorting comes specifically because people expect a stock to significantly fall.
Many analysts will see the short interest ratio as an indicator of how the market views a particular stock. As a very rough rule of thumb used by some analysts, a ratio of 5.0 or more is a sign that the market overall expects the stock price to fall. A ratio of 3.0 or less suggests the market as a whole expects the stock price to rise.
There are some limitations to how informative a short interest ratio is. That’s because some shorting is carried out for reasons other than a strong expectation of a drop falling. Shorting could take place because of hedging, a tactic by which investors will make seemingly contradictory investments so that their losses are minimized if their expectations prove wrong. Shorting may also be the result of arbitrage in which investors take advantage of differing prices in different markets, such as when a stock is available on more than one stock exchange. For these reasons, investors tend not to rely on the short interest ratio as a conclusive guide to how stocks may perform in the immediate future.