Short interest on a stock (the number or percentage of outstanding shares that are currently shorted) is one measure of negative market sentiment toward that stock. The more shares of a company are sold short, the more players in the market will bet that the value of the shares will drop.
Some contrarian traders are particularly interested in heavily shorted stocks, as they may have the potential for a sudden rise in value due to a phenomenon known as a short squeeze — but only if, contrary to market expectations, their price goes up.
What is a short interest rate (AKA Days to Cover)?
Days to cover (also known as short interest ratio) refers to the estimated number of days it will take to cover all open short positions on a stock (buy them back and return them to the lenders) given the average share trading volume (how many) of their shares tend to change in a day specific circulation).
In other words, days to cover represent how long a stock’s short squeeze might last if, in fact, an unexpected rally were to occur. The more stock days to cover, the more likely the potential short squeeze will continue, and the more money the bulls (the holders of long positions or call options) may make.
How is the short interest rate calculated on a stock?
To calculate the days to be covered, simply divide the short interest per share (the number of shares currently sold short) by the average daily trading volume.
days to cover the formula
DTC = Number of Open Short Positions / Average Daily Volume
Why is the short interest rate on stocks important?
Short sellers make money by borrowing shares they think are on a downward price path, immediately reselling them at the current market price, then buying them back at a lower price sometime later, returning the shares to their lender, and pocketing the difference between the initial sale. price and subsequent repurchase price.
When the short seller sees the shares they shorted start to appreciate, they may have reason to panic — after all, they owe the borrowed shares to the lender no matter what happens to the share price. And because stock prices have no ceiling, the possibility of losing them is unlimited.
Therefore, when the stock is significantly short Do As it starts to rise, the pressure mounts on the short sellers to buy back and put the exposed shares back as quickly as possible because the longer the rally continues, the more each short seller will lose their incorrect bet if they don’t close their position.
At the same time, the longer the short squeeze period, the more money contrarian investors with long positions can make as the stock price continues to rise day by day due to high demand and limited supply.
How do you interpret the days to cover
If the stock’s short interest ratio is less than 1, this means that all open short positions could theoretically be covered in a single day, assuming trading volume remains at or above the average. A reading of 2 indicates coverage will take 2 days, and so on.
It’s important to remember, however, that a stock’s average daily trading volume is rarely the same as a stock’s actual trading volume on any given day. During a short period of stress, the stock’s trading volume can differ significantly from its average as news of an unexpected rally spreads and public interest in the stock increases.
Anyway, even though the days to cover are a crude estimate at best, the higher the ratio, the longer and more extreme the short squeeze the stock is prepared for if it starts to rally.