Definition of a Short Interest Ratio
When trading stocks, there are many variables that investors look at when determining their next investment move. One of those variables is something called short interest ratio. While many people purchase stocks and hope they go up, there is another side of the market that takes the opposite bet. They "sell" stocks hoping that they go down. In this inverse relationship, the "short investor" is rooting for the stock to fail. By calculating the short interest ratio an investor can determine if the rest of the marketplace believes a stock is going to go up or down.
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Equation
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The equation to calculate short interest ratio is fairly straightforward. The short interest is divided by the average daily volume. Therefore the equation would read:
Short Interest Ratio = Short Interest / Average Daily Volume
Short Interest Release
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The two main exchanges in the Unites States, the Nasdaq and New York Stock Exchange, release their short interest at the close of trading two times a month. Each year they issue a schedule of those dates ahead of time so that investors can be aware of when the information will hit the street.
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Average Daily Volume
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The average daily volume of a security helps investors determine exactly how many shares are traded of that security over the course of time. The longer the amount of time, the better the long-term average. In terms of calculating the short interest ratio, the average daily volume is calculated over the course of one year. This gives 250 trading sessions to create that average since there are 250 trading sessions in a given year.
Days to Cover
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Days to cover is the reason to calculate the short interest ratio. This will tell investors how long it will take the shorts (people who are betting that the stock will go down) to close their positions and buy the stock. (Remember that when you short a stock, you sell it first, and then buy it. If you buy it at a lower price you have made money. If you buy it at a higher price you have lost money.) For example, say a company at a short interest of 4 million shares and an average volume of 2 million shares, the equation would read:
4 million / 2 million = 2
In this equation the short interest ratio, also known as days to cover, would equal 2. This means during average volume, it would take shorts two days to cover their trade.
Short Squeeze
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A short squeeze is created when there are a lot of investors who are shorting the stock who suddenly need to buy it back. Many investors will use the short interest ratio to identify when a short squeeze might take place. They would then buy the stock hoping for a quick rise in price. For instance, say a stock was heavily shorted and had a number such as 10 days to cover because a lot of investors thought a company was going to miss earnings. If the company beat expectations, that would send the shorts scrambling to get out of the trade and buy the stock back at a frenzy. If you were long (meaning you bought the stock and wish it to rise) you might suddenly have a nice surprise as all of the shorts are "squeezed" out of their position. In this manner, the short interest ratio can help identify a short squeeze.
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References
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