What You Need to Know About Short Interest

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running a weekly post about options education. Last week, we covered the basics of pairs trading. This week, we will be diving into the definition of short interest.

Short interest measures the level of investor pessimism toward a certain stock. More specifically, it is created when investors sell shares that they do not own outright, but can borrow from a broker. In doing so, they are hopeful that the security's price will drop, so that they can buy the shares back at a discount later on. In other words, if a stock's price declines, investors can buy the cheaper shares and return them to the broker. Since the shares they returned cost less than what they made selling the borrowed stock, they are able to turn a profit.

There are risks associated with this type of trading. For instance, if investors are wrong about a stock and the price rises, they could lose money when they buy shares back at a higher rate. A broker could also demand a position to be closed out at any given time, forcing investors to buy shares back and return them regardless of the stock's current price.

Things can snowball quickly when these bearish bets are proved wrong. If a stock increases dramatically, investors who were selling shares short rush to buy the stock back as soon as possible, in an effort to curb further losses before prices become even higher. This rush to buy back the stock is called a short squeeze, and it only serves as additional tailwinds to the security in question. Finding stocks that are heavily shorted and could be ripe for a short squeeze is a key component of contrarian trading.

When it comes to short interest, there are key indicators investors should be mindful of. Nonetheless, these definitions are valuable when trying to decide on how to invest in an equity.