In the Dugout: Using Short-Interest as Contrarian Indicator

The term short interest we are talking about in this lesson isn't referring to the amount of time your kids listen to you. No, what we are referring to is the amount of shares that are being traded short on specific stocks. Shorting stock is a bearish strategy. It is when a trader borrows stock from a broker at a price he/she feels is higher than where it will be down the road. If the stock reaches a lower level, the trader can buy the shares at a lower price to replace the shares that were borrowed and sold at a higher price. The idea of this lesson isn't to go into the specifics of shorting stock, but rather to use short-interest data as a contrarian indicator.

Each month, data is released that give the number shares short on a stock and what is called the short interest ratio. The ratio is a number that indicates how many days it would take at normal trading volumes for all the shares short to be covered. Let's look at an example.

Veritas Software (NASDAQ:VRTS) had a short-interest ratio of 9.53 when the data was released on September 8. This is an extremely high number telling us that it would take nearly 10 days at normal volume to just cover the shorts. When this many shares are being shorted, it sets up a situation that could create a short squeeze. Let me explain. If you are short a stock and you expect it to go down, if it turns up and starts to rise, you will cover your short so that you aren't losing a bundle of money as the stock rises. When you cover your short position, you are going into the market and buying shares. This adds to the demand, helping support prices further. When there are many people short on a stock, it creates a situation where a mild rise in the stock can turn into a large gain in a relatively short amount of time, called a short squeeze.

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Notice how when VRTS started to rise, volume started to increase and the stock went much higher in a short amount of time. A classic short squeeze. Does this mean we immediately jump into stocks that have high short-interest ratios? Definitely not, but if a stock does have a high short interest figure, then it is worth watching. Remember, when too many people jump on.

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