If you think the price of a stock is going to rise, then the strategy for making a profit is simple: Buy shares of the stock, wait for the price to go up and then sell them at a profit. If you expect the price to fall, however, things get more complicated. You need a way to sell the shares first, when the price is high, then buy them later, after the price has gone down. That's what short selling is for. In a short sale, you borrow shares from a broker or dealer and sell them at the current market price. Later on, after the price falls, you buy the same number of shares and return them to the broker. The difference between two prices becomes your profit. Of course, if the price goes up rather than down, you'll lose money.
A stock's "short ratio" tells you how strongly the market believes that the price of that stock is headed downward. The higher the ratio, the more pessimistic -- or "bearish" -- the sentiment. At the same time, though, the higher the ratio, the harder it may be for a trader to make a profit off that pessimism.
Stock exchanges track how many shares of a stock have been sold short but have not been "closed out," meaning the short seller has not yet repurchased shares to return to the broker. The number of such shares is called the "short interest" in the stock. When you divide the short interest by the average daily trading volume of a stock, you get the short interest ratio, often called just short ratio. For example, say a particular stock has a short interest of 15 million shares, and in an average day 6.5 million shares of that stock change hands. The short ratio is 15 million divided by 6.5 million, or about 2.3.
Interpreting the Ratio
The short ratio gives you a general sense of the market's sentiment toward a stock. The higher the ratio, the stronger the belief that the stock is going down. By no means does a high ratio guarantee that the price will fall. "Shorts," like any other traders, are sometimes wrong. But it tells you that not only are traders of the opinion that the stock will fall, but they've also put a lot of money behind that opinion. Because it relates the short interest to the daily trading volume, the ratio also tells you roughly how long it would take for all short sellers to close out their positions. A ratio of 2.3, for example, means that at current trading volume, it would take 2.3 days for all shorts to buy back enough shares. For this reason, short ratio is sometimes also referred to as "days to cover."
As the short ratio increases, so does the possibility of a "short squeeze." Say you've shorted a stock, and the price either stops falling or begins to rise. When that happens, you want to buy back shares to lock in your profit -- but so does everyone else who has shorted the stock. The higher the ratio, the more likely that the demand for shares will outstrip the supply. That in itself will cause the price to rise -- which may attract other buyers, driving the price even higher. This is the short squeeze. As the price rises, the shorts' profit shrinks. If it rises high enough, the shorts will have to pay more for the replacement shares than they received for selling the borrowed shares. Their profits turn into losses -- and there's no limit to how much they can lose.