Amount of Short Interest
Short interest is a measure of how aggressively a stock has been borrowed and sold in anticipation of declining prices. Unlike purchases, short interest has to be reported, and aggregate figures produced from such reports are made available to investors free of charge. The amount of short interest in a stock is not always easy to interpret and might signify a price drop as well as appreciation, depending on the surrounding circumstances.
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Short Sales
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Short selling refers to the practice of borrowing shares, or other financial assets where short sales are allowed, to sell them at prevailing prices, with the intent of buying them back at a lower price point. While not permitted in every stock market around the globe, the practice is legal in American stock exchanges. Short sellers benefit from price drops in a security but take on an unlimited risk, while the purchase of a stock always carries a limited and easily quantified loss potential. Short sales are subject to more strict regulations compared to outright purchases, because conflicts of interest arise more easily.
Example
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Assume an investor, say Investor A, has bought 100 shares of Microsoft stock, which she is holding in an investment account. A second individual, Investor B, believes that Microsoft stock has appreciated too much, too fast and expects a price drop. Investor B will, with the permission of the brokerage house, borrow those 100 shares from Investor A's account and sell them at the prevailing price of $20 per share, for total proceeds of $2,000. If the price drops to $18 per share, he can use $1,800 of the proceeds to buy back the same 100 shares and pocket the $200 difference as profit. Should Microsoft stock appreciate, the sales proceeds of $2,000 will no longer be enough to buy back 100 shares, and Investor B will be required to put up additional capital to replace the shares he sold earlier, resulting in a net loss.
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Tracking
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Every short sale must be reported by the brokerage firm to the regulatory bodies, such as NASDAQ. These regulators compile the total outstanding short interest for each security and report it periodically. The total short interest for a particular stock is the aggregate amount of borrowed shares that must eventually be bought back and replaced. Another reason short sales must be reported to regulators is that many individuals and institutions are barred from selling short. Employees of a company can buy stock in their firm, but, because of potential conflicts of interest, cannot sell it short. Mutual funds usually cannot engage in short sales either.
Interpretation
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Short interest is an important metric for stock analysts. It is, however, difficult to interpret. Because every share borrowed must eventually be bought back, a high short interest might signal an eventual buying spree and higher prices. On the other hand, if a large number of investors placed pessimistic bets on the stock by selling it short, the firm's future may not be very bright, and lower prices might be inevitable over the long run. The short interest figure must be considered as one part of a large puzzle and not interpreted in isolation.
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