One of the most important things investors want to know about a stock is its future movements. Unfortunately, no one can predict them with 100% certainty. But investors can use various tools to figure out the general sentiment towards a particular stock. The short interest ratio is one of these tools.

The short interest ratio measures the outlook investors have towards a particular stock. It takes the number of shares held short and divides that by the average daily trading volume. This provides investors with a look into how other investors feel the stock is going to perform in the future.

The ratio is easy to calculate and can be a powerful tool. Here’s a closer look at this metric, how to calculate it and how investors can apply it to their investment decisions.

holding a short interest ratio sign

Why is it Important?

The short interest ratio can tell investors two main things about stocks. The first thing it tells investors is if a stock is heavily shorted. Generally, a higher ratio means that more investors are shorting the stock. Now this isn’t always the case, but we’ll get into that later.

The other insight investors can gain from this ratio is the days to cover for the stock. In fact, these two terms are often used interchangeably. This metric tells investors how many days it would take for the shorted shares to be repurchased in the open market.

Formula and Calculation

As previously mentioned, the short interest ratio is easy to calculate. In fact, this ratio can be found in stock summaries on most financial websites. But if you want to calculate it yourself, here’s the formula:

Short interest ratio = SI / ADTV 

In the above formula:

  • SI = Short interest
  • ADTV = Average daily trading volume

The short interest is the total number of shares sold short in the market. And this is an easy number to find. Financial Industry Regulatory Authority (FINRA) requires companies to report it twice each month. You can find it on most financial website like Google or Yahoo Finance.

Average daily trading volume is the total trading volume for a period divided by the number of days. This is another figure that most major financial websites publish. Now let’s look at an example of how to calculate this.

Let’s say the XYZ Company reported a short interest of 200 shares. It also has a 10-day average daily trading volume of 1,000 shares. Using the above formula, the short interest ratio for the XYZ Company would be 0.2 (200/1,000 = 0.2).

An Evaluation Metric

Once you have the short interest ratio, what do you do with it? Its mainly used is to show investors’ outlooks on a stock’s future performance. A higher number typically means a more pessimistic view. But there are a few things investors should keep in mind when using this ratio.

When using this ratio as an evaluation metric, an increase doesn’t necessarily mean rising short interest. A decrease in trading volume can also lead to a higher short interest ratio. And there are many factors that can impact average daily trading volume. Of course, the opposite can also be true.

To use the short interest ratio as an evaluation metric, it’s important to also look at the short interest and trading volume on their own. Examining both variables alongside the ratio allows investors to get a better picture of what might be impacting the ratio. And this helps investors make better investment decisions.

Shortcomings of the Short Interest Ratio

Like any financial metric, there are shortcomings to the short interest ratio. The first is that the short interest is not updated regularly. While companies are required to report it every two weeks, it can take a while for it to publish. This means that by the time the information reaches investors, it’s already outdated.

The other shortcoming is that trading volume can be impacted easily which causes the ratio to change regardless of the short interest. But, as previously mentioned, looking at the ratio alongside its variables allows you to get a better picture of what’s going on.

What’s a Good Short Interest Ratio?

It’s difficult to definitively say what a good short interest ratio is. It depends on the company and many outside factors. But with this ratio, a lower number is usually better for buy and hold investors. And in general, anything above 10 indicates extreme pessimism about the future performance of the stock.

The Bottom Line on the Short Interest Ratio

The goal of investing is almost always to pick stocks you think will perform well in the future, but that can be hard to do. There are many factors that go into a stock’s overall performance. But metrics like the short interest ratio allow investors to gain insight into other people’s predictions for stocks. It’s a powerful tool you should consider using when making investment decisions.

If you’re looking to learn more about investing, check out these investment newsletters. They’re free and you’ll hear tips and tricks from investing experts. You’ll also find investing strategies and opportunities.