High short interest indicator strategy

Is high short interest good or bad? Short interest in trading has been a hot topic during 2021 after Gamestop made short-sellers run for cover at prices many times higher than their entry price. But was the short squeeze in Gamestop an outlier? Which stocks perform better – stocks with high or low short interest?

The empirical evidence suggests that stocks with high short interest perform worse than stocks that have little short interest. Thus, short squeezes like happened in Gamestop are not the norm – they are outliers.

Related reading: Stock indicators list

We start by discussing short interest and later explain what a short squeeze is.

What is short interest? What is the short-interest ratio?

The short interest is based on the number of shorted outstanding shares. For example, if a company has 1 billion outstanding shares and 50 million are sold short, the short interest is at 2%.

Short interest is thus a percentage of the number of shorted shares divided by the total outstanding shares.

The short-interest ratio measures the average number of days it takes for short sellers to cover their short position. The ratio is calculated by dividing the number of shorted shares by the average daily volume. For example, if the short interest is 5 million shares and the daily turnover is one million shares, then the short-interest ratio is five.

How do you find short interest for a stock?

FINRA requires broker-dealers to report their short positions twice a month. This applies to both retail accounts and proprietary trading companies.

What is FINRA?

FINRA was set up to protect investors and ensure the market’s integrity. It’s a government non-profit organization and regulates all broker-dealers in the US.

Because of the reporting requirement, finding the short-interest ratio in listed stocks is relatively easy. For example, the popular website Seeking Alpha has short interest listed on the landing page of every ticker.

New York Stock Exchange short interest

Based on FINRA’s biweekly reporting, the New York Stock Exchange develops a Group Short Interest file available via subscription for all the stocks listed on NYSE, ARCA, and AMEX.

The data can simulate risk and trading models for NYSE-listed stocks. NYSE’s numbers, or those from Compustat, are used in most of the research reports you find online.

What is a high short interest?

A high short interest might signal investors are pretty pessimistic about the prospects for the company. Likewise, sudden changes might be positive and negative, depending on the circumstances.

In June 2021, Nasdaq published an article called The Predictiveness of Short Interest. The exact level of short interest among deciles (all stocks divided/ranked into ten parts) varies across different market environments and times, but the report provided interesting insights: the most shorted stocks have a short interest of about 20%, while the lowest deciles have less than 2%:

Most likely, the short interest gives us indications about the quality of the company. Hedge funds are frequent short-sellers and serve a useful purpose in the market ecology: they are good at price discovery.

We argue short-sellers are needed to make a better market. Short selling is difficult and we should be happy investors are willing to compete in this challenging business.

Is High Short Interest Good Or Bad?

Let’s look at some facts and numbers instead of anecdotal evidence:

The Nasdaq article we referred to above, written by Brian Bruce and named The Predictiveness of Short Interest, the conclusion is that high short interest is followed by weak returns. Brian Bruce made the following chart (one-year returns):

The study looked at Russel 3000 stocks from 2000 until 2020.

On the left side, we see that the deciles with the highest short interest have the weakest performance. Hence, high short interest is bad for future returns.

Anecdotal evidence might suggest that high short interest might start short squeezes (see more below), but the data above clearly illustrates that it’s not a good investment idea to buy stock with high short interest in the long run.

Low short interest companies outperform the average company in the universe while companies with high short interest conversely underperform.

Is the conclusion above in bold supported by other research?

The CFA institute published a report in December 2016 called Short Interest and Aggregate Stock Returns. The report looked at all stocks except small-caps from 1973 to 2014 and confirms the results above. The conclusion is pretty straightforward:

High short interest predicts a lower equity risk premium and, in turn, lower future excess returns.

What is a short squeeze?

At the beginning of the article, we mentioned that the Gamestop debacle in 2021 was a classical short squeeze. What is a short squeeze? A short squeeze looks like this (chart taken from Seeking Alpha):

The stock price went ballistic in early 2021 when short sellers were required to buy back their borrowed shares. In other words:

A short squeeze happens when those that are short need to buy back the shares in the market.

Victor Niederhoffer had a fantastic description of a short squeeze in The Education Of A Speculator. On pages 267-268 Niederhoffer wrote this:

I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”

This is precisely what happened in many stocks during the many short squeezes in 2021, for example, in Gamestop (GME). The short-sellers were squeezed and they were forced to cover at rising prices. Sellers required higher prices to sell and the price went ballistic.

When a stock rises in value, many short sellers that have sold on margin might need to cover, or their broker issues a margin call. This is like adding fuel to the fire. Not only has the stock “natural” buyers, but when short-covering enters the arena, the result might be explosive.

A short squeeze results from a lack of supply and high demand. Higher prices solve this. To our knowledge, the short squeeze in Gamestop in 2021 is one of the most dramatic ever: Gamestop went from 5 USD a share to a top of 300 USD! Imagine being short at 5 USD and watching the price double many times….. This illustrates the dangers of shorting: the potential risk is unlimited. This is just one of the many examples of why short selling is difficult.

That said, we have tried to develop a short squeeze trading strategy. But because squeezes are rare and random, we decided our resources were better spent elsewhere.

What triggers a short squeeze?

We suspect it’s very hard to predict a short squeeze. Using hindsight bias it’s easy to explain, but there are many stocks that have a high short interest without ever causing a short-squeeze.

Can you profit from a short squeeze?

Traders can, of course, make huge profits from short squeezes. However, this is a trading strategy that is hard to predict. No one knows when a short squeeze is going to happen and even a high short interest might not trigger a squeeze as indicated in the research we mentioned above.

Is short selling a good strategy?

No, short selling is most likely not a good strategy, and short selling is difficult. When short, you are betting against the long-term tailwind in stocks. The stock market has risen about 10% annually for over a century, and it goes without saying that it’s hard to make money on the short side by betting against this tailwind.

Nonetheless, short-selling could be part of other strategies, like, for example, pairs trading. Even though shorting might not be so effective in the long run, it can still offer sound risk mitigation for a portfolio. We have described the value of risk mitigation in a previous article about Mark Spitznagel’s Safe Haven Investing.

Even for short-term traders, you can find a few short setups that offer reasonable risk and reward. We present a few of those in our monthly Trading Edges.

Short interest and short ratio video

Conclusion: Is High Short Interest Good Or Bad?

Is High Short Interest Good Or Bad? The empirical suggest a clear no. High short interest is bad for stocks.

The long-term empirical results suggest that high short interest is bad for future returns. The reason is probably simple: good companies are less likely to have their shares shorted.

For example, why would you short Visa (V)? The company most likely has a huge moat and despite high multiples, it doesn’t seem smart to short the stock.

Al in all, we can safely conclude that high short interest is bad for future returns.

FAQ:

What does the short-interest ratio indicate?

Short interest is the percentage of shorted outstanding shares compared to the total outstanding shares.The short-interest ratio measures the average number of days it takes for short sellers to cover their short position. It is calculated by dividing the number of shorted shares by the average daily volume. For example, if a company has 1 billion outstanding shares and 50 million are sold short, the short interest is 2%.

How can I find short interest for a specific stock?

Broker-dealers are required to report their short positions twice a month, and this information is available through platforms like Seeking Alpha. Additionally, FINRA regulates broker-dealers and ensures reporting compliance. FINRA, a government non-profit organization, was established to protect investors and ensure market integrity.

How can traders profit from a short squeeze?

A short squeeze occurs when those who are short a stock need to buy back shares in the market. It often happens when the stock price rises, and short sellers are forced to cover at higher prices, leading to a surge in demand. Traders can potentially make significant profits from short squeezes by taking advantage of rising prices when short sellers cover their positions. However, predicting and timing short squeezes is challenging.