Short Ratio Explained: Why It Changes The Game

Short ratio is not to be mistaken for short interest. They are heavily connected terms, however, completely different. Short interest is the total amount of shorted shares in a stock, while short interest ratio is an equation that uses the short interest in its formula.

Short ratio (short interest ratio (SIR) or days-to-cover) is a vital trading metric for short sellers assessing when to cover their shorts. The short interest ratio is equal to the total amount of shorted shares divided by the average daily trading volume. With the short interest ratio or SIR, traders can figure out how many days it will take for all the shorts to be covered.

With this information, short sellers can plan their next moves. However, just knowing the short ratio is not enough to make an educated plan of action. To successfully engage in short-selling, it’s important to know each of the components of the short ratio equation, how to interpret the results, and how to properly apply them.

The main benefit of understanding the short interest ratio is the trader’s ability to anticipate momentum shifts, short squeezes, and potential opportunities. We’ll cover all of that here.

The short interest ratio shows the number of days the short sellers would need to cover their shorts, or rather how many days it would take the traders to buy back all their borrowed shares. The goal of the short ratio is to allow traders to identify trading trends, like a short squeeze.

The equation is calculated by dividing the number of shorted sales, which is called short interest, with the average amount of daily trades, usually lasting 30 trading days. The result is the ‘short interest ratio’.

If short interest is 1 million shares and the average daily volume is 200,000 shares, then it would take all short sellers 5 days to cover all short positions, hence the second name of this equation: “days to cover.”

Abbreviations related to the formula include:

SIR: Short Interest Ratio

SI: Short interest

ADTV: Average Daily Trading Volume

As stated previously, understanding how the equation works and what it represents is one thing. However, being able to read it properly and apply it by anticipating trends can potentially provide a trader with a slight edge. Traders can expect either a low short ratio or a high short ratio, each indicating opposite trends.

A high short interest ratio means it would take many days to cover all short positions. The reason for a high short ratio can either be a lot of shorted shares or low average daily trading volume—or both. This is often seen as a warning sign for short sellers, as a high short ratio can imply bearish sentiment, illiquidity risk, and the potential of a short squeeze. All factors negatively affect short sellers.

A low short interest ratio signifies that it would take only a few days to cover all the short positions. Usually, because there aren’t a lot of shorted shares, the average daily trading volume is high, or both. While a high short ratio indicates high risk, a low short ratio has less significance for short sellers, as it can indicate stability or neutrality in the stock’s direction.

Short sellers tend to stay away from high short interest ratios because of the negative consequences that may hinder their profits. The biggest concern with short-selling is the risk of a short squeeze, which is a situation induced by positive news surrounding the company that makes the value of the stock rise.

Traders who have shorted such a stock will face a costly surprise, as they need to cover their shorts at higher prices. The more traders buy back, the more the value of the stock rises, initiating the short squeeze cycle. While short sellers are trying to cover their shorts, traders might be blocked by the trade limit due to the crowdedness of the shorted stock, inadvertently making them buy back at higher prices.

To illustrate with a hypothetical example of a short squeeze: 1000 short sellers sold stock 1, however, it rises in value due to an innovation the company made. The daily trade limit is 200, leaving 800 short sellers hoping to buy back as soon as possible while the price is getting higher due to real value and demand.

One of the biggest short squeezes in history happened in 2021- the GameStop surge, where the price of one share jumped from $17.25 to a whopping $483. A large number of Redditors came together to drive up the price of GameStop shares. Short sellers, caught in the squeeze, reportedly lost over $6 billion as they were forced to buy back shares at much higher prices.

For this reason, short sellers must use the short interest ratio formula and anticipate the right timing to sell a short, but more importantly, the proper opportunity to buy it back, alleviating risks of profit losses.

Traders can improve timing by cross-referencing short ratio data with volume spikes, trend reversals, or breakouts above resistance - signaling that shorts may start unwinding.

By using the short ratio, a trader can understand that 2 days to cover is considered a low short interest ratio, and it can indicate that the shares are ripe for selling. However, a trader also needs to acknowledge that a high short interest ratio of 5 days to cover is generally considered a long time.

Traders who have already shorted a stock that has later gained a high short interest ratio should consider covering their shorts. While traders looking for opportunities to short-sell should stay away from these kinds of shares.

However, for long-biased traders, a high short interest ratio combined with increasing volume or a technical breakout may indicate a squeeze setup. This provides an opportunity to capitalize on the upward momentum triggered by short covering.

Platforms like TradeZero provide real-time short interest data, customizable short locate tools, and live charts - helping traders act quickly and with precision when using the short ratio as part of their strategy.

TradeZero offers a proprietary locator system designed for short sellers to access borrowable shares efficiently.

Traders can use standard Locates for non-threshold securities, which allows them to short and cover the same stock multiple times in a day. For threshold securities, the platform provides Single Use Locates that permit a one-time short, and if the locate goes unused, the fee is refunded. Pre-Borrows are available for hard-to-borrow stocks, giving traders the ability to secure shares in advance and reduce the risk of buy-ins.

TradeZero also offers a curated list of stocks available for shorting. Fees are quoted per share in real time based on availability and demand. Real-time short interest ratio tracking allows traders to see how crowded a stock is.

Great short sellers may use the short interest ratio to anticipate trading trends. However, using it on its own is not enough as it is only one piece of the puzzle.

Short interest ratio can’t account for news, FDA approvals, social media hype, or other real-life situations that can impact stock value. The short ratio is not capable of anticipating sudden shifts in sentiment, nor does it have the capacity to showcase its source. It doesn’t reveal the directional intent, just how many shares are shorted.

Similarly, the short ratio is not able to reveal who the short sellers are, meaning traders are not aware who is behind the move - institutional investors using complex hedging strategies are less prone to short squeezes, are much more patient and less reactive to small price moves. Neither is the formula able to account for their commitment or the heaviness of the leverage.

Traders should combine the short ratio with other tools for a more comprehensive analysis. For example, technical indicators like moving averages and support/resistance levels can provide insight into potential price movements. For example, if a stock breaks above a key resistance level, it could signal a bullish trend.

Considering the stock's float size and volume context helps assess how easily the stock can move in response to buying pressure - a stock with a low float and high volume may experience significant price swings when buying pressure increases, meaning that it is more prone to short squeezes.

Market trend analysis also plays a crucial role in understanding broader market sentiment. Additionally, incorporating risk management strategies such as stop-loss orders can help protect against significant losses if the trade doesn’t go as planned.

Short interest ratio is an essential tool for short sellers trying to anticipate the trading trends. It can help alleviate the risk of losses once traders have already shorted a stock. However, it has its limitations and should not be used on its own.

A great short seller must be able to combine a short interest ratio formula with elements of other trading tools, strategies, and analysis, allowing the trader to cover the shorts successfully.

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