What Are High Short Interest Stocks?

The amount of stock in a company that has been sold short — not just sold to close out a long position — is known as the short interest. High short interest stocks consist of corporate stocks that have been heavily borrowed to sell short by speculators in the hope of buying the stocks back for less in the future.

The risk of shorting a stock is that the trader remains obligated to buy the stock back eventually. If the stock’s price rises, then this repurchase price could be considerably more than the shorted price, causing the short seller to take a loss.

A high short interest stock is one in which the amount of stock shorted by speculators makes up a large part of the amount of stock outstanding or may even exceed the outstanding amount. Such stocks can present significant opportunities for investors, so keep reading to find out how to identify such stocks and how they can offer a decent investment. 

What is Short Interest?

Before defining short interest, it makes sense to clarify what selling short is and what it entails. Selling a stock short involves first borrowing the stock you wish to short. Speculators trading through a broker can generally short stock held in the broker’s inventory. It tends to impede short sales from occurring in a particular stock if that stock is hard or costly to borrow.   

Short interest stock is the percentage of a company’s outstanding stock that has been sold short. For example, if Tesla Inc. (NASDAQ: TSLA) stock had a float size of 809,270,000 shares with a total short interest of 22,470,000 shares sold short, it would bring the short interest of TSLA stock to 2.78% of the overall float amount.   

What Does Short Interest Tell Investors?

An increase in a stock’s short interest traditionally indicates that speculators increasingly believe that stock would decline in price. In today’s market, many other important factors could be at work to create a substantial rise in a stock’s short interest.

Transactions that could increase a stock’s short interest without indicating a bearish view would include selling stock short to partially offset a long call option position or fully offset a long synthetic stock position created by buying a call and selling a put option with the same strike price. 

Interesting phenomena can occur when a large aberration in the market exists because of excessive short sales in a company’s stock. For example, GameStop Corp. (NYSE: GME) and AMC Entertainment Holdings Inc. (NYSE: AMC) stocks drew considerable attention in the financial press in 2020 and 2021 after major hedge funds had notably shorted the stocks and members of a large investor group on Reddit called r/wallstreetbets decided collectively to buy those stocks to cause short squeezes. 

What is a Short Squeeze?

A short squeeze consists of an upward spike in a stock’s price from the covering of short positions. Traders cover short stock positions:

• to avoid losses when the market is moving higher
• when the stockholders that loaned the stock to the short sellers request their stock back 
• if the short seller does not have the funds to hold the losing short position 

Short covering tends to magnify a stock’s price rise as more short-sellers scramble to cover their short positions, eventually leading to a short squeeze. This phenomenon was behind the GameStop short squeeze that took place in late January 2021. 

Although the rise in GME stock was furthered by the many speculators who bought the stock, including the r/wallstreetbets investor community on Reddit, most of the buying that prompted the short squeeze was panic short-covering by hedge funds that had shorted the stock heavily throughout 2019 and 2020.

As illustrated in the price chart below, the infamous short squeeze saw GME’s stock price increase sharply by a factor of over 25. The stock rose from $19 per share on January 12, 2021, to a high of $482 per share on January 28, 2021. 

Chart for GME stock showing the short squeeze in late January 2021. Source: Benzinga Pro

How to Calculate Days-to-Cover

Calculating the days-to-cover can be useful for those looking to buy high short interest stocks since it indicates the number of days of normal volume activity it would take for all the outstanding short stock in a company to be covered.

To compute the days-to-cover, you take the average daily trading volume of the stock and divide that by the number of shares that have been sold short — the short interest.   

For example, if the total amount of shorted stock in a company is 3 million shares, and the stock’s daily volume is 6 million shares, then the days-to-cover would be 2. It would therefore take 2 days of normal trading for short sellers to cover all their outstanding short stock.

Days-to-cover increases as the amount of short stock outstanding rises and falls as the daily volume traded in the stock increases. Thus, if the stock’s short interest is 20 million shares and its average daily trading volume is 2 million shares, then it would take 10 days of normal trading to cover those shorts.    

How to Use Short Interest

Short interest was once a reliable indicator of shorts that could be pressured by a short squeeze in the days before derivative financial products. Since derivatives — indices, futures and options contracts — routinely affect the amount of short stock at any given time, the value of short interest as a short-squeeze indicator has declined considerably.

While short interest can still be used as an indicator of a stock’s possible future direction, it tends to be less reliable now for major stocks because of the impact of derivatives. Since not all stocks have derivatives like listed options or futures available for trading, short interest can be a more reliable short squeeze indicator for such stocks.

The general investor consensus at present is that high short interest could be a negative indicator for a company’s stock, although an excessive amount of short interest could trigger a short squeeze. Basically, short interest in and of itself should be seen as a neutral indicator, especially if options are traded on the stock. 

Disadvantages of Short Interest

As mentioned above, the main disadvantage of using short interest is that it tends to be an unreliable indicator for major stocks with a substantial derivatives market.  Furthermore, observing substantial short interest — even in a stock without a derivatives market — does not always suggest a short squeeze is probable.

High short interest stocks should generally be thoroughly researched before taking a long position just because it seems cheap because the reasons speculators have for shorting that stock could be well-founded.

For example, if a company is running at a loss with deteriorating fundamentals that could lead to bankruptcy or if a company decides on an unfavorable change in its business model, then selling its stock short might seem justified. Keep in mind that subsequent attempts to turn the company around that the market views as favorable can reverse this situation quickly, however.

In the case of GameStop, the company was seeing declining customer interest and sales at its gaming stores, which suggested that it might go out of business. The stock thus attracted substantial short-selling activity that eventually led to an overwhelming amount of short interest.

GameStop’s new management decided to shift the retailer out of its traditional brick-and-mortar store business, however, to focus on a more streamlined online presence for selling games. This move partly prompted the notable short squeeze seen in January 2021. 

Compare Online Stock Brokers

If you plan on trading in high short interest stocks, or if you plan on shorting stocks yourself, the broker you select could make a substantial difference to your bottom line, as many traders found out during the Game Stop short squeeze. To make finding a suitable broker easier, you can check out the list below of Benzinga’s picks for the best online broker.

Are High Short Interest Stocks a Good Investment?

Depending on the stock and its current situation, some high short interest stocks might be worthy of consideration.  Keep in mind that short selling and buying high short interest stocks involve taking risks, so these strategies may not suit investors with a low pain threshold.

Before investing in high short interest stocks, you will want to develop a thorough knowledge of the company, its assets and its business model. You would also be wise to review how the company compares to others in the same industry before jumping into a high short interest stock with both feet.

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