A stock’s short interest (the number or percentage of its outstanding shares that are currently sold short) is one measure of negative market sentiment toward that stock. The more of a company’s shares are sold short, the more players in the market are betting that stock will fall in value.
Some contrarian traders are particularly interested in stocks that are heavily shorted, as they may have the potential to suddenly skyrocket in value due to a phenomenon known as a short squeeze—but only if their prices go up, against the predictions of the market.
What Is a Short Interest Ratio (AKA Days to Cover)?
Days to cover (also known as a short interest ratio) refers to the estimated number of days it would take for all of a stock’s open short positions to be covered (repurchased and returned to their lenders) given that stock’s average trading volume (how many of its shares tend to change hands on a given trading day).
In other words, days to cover represents how long a stock’s short squeeze might last if an unexpected rally does, in fact, occur. The higher a stock’s days to cover, the longer a potential short squeeze might last, and the more money that stock’s bulls (those with long positions or call options) might stand to make.
How Is a Stock’s Short Interest Ratio Calculated?
To calculate days to cover, simply divide a stock’s short interest (number of shares currently sold short) by its average daily trading volume.
Days to Cover Formula
DTC = Number of Open Short Positions / Average Daily Trading Volume
Why Is a Stock’s Short Interest Ratio Important?
Short sellers make money by borrowing stocks they believe are on a downward price trajectory, reselling them immediately for their current market price, buying them back at a lower price sometime later, returning the shares to their lender, and pocketing the difference between their initial sale price and their subsequent repurchase price.
When a short seller sees a stock they’ve shorted begin to rally, they may have reason to panic—after all, they owe the borrowed shares back to their lender regardless of what happens to the stock’s price. And because stock prices have no ceiling, their loss potential is unlimited.
So, when a heavily shorted stock does begin to rally, the pressure mounts for short sellers to repurchase and return shorted shares as quickly as possible because the longer a rally continues, the more each short seller loses on their incorrect bet if they haven’t closed their position.
At the same time, the longer a short squeeze can continue, the more money contrarian investors with long positions can make as a stock’s price continues to jump day after day due to high demand and limited supply.
How to Interpret Days to Cover
If a stock’s short interest ratio is below 1, that means all open short positions could theoretically be covered in a single day, assuming trading volume remains at or above average. A reading of 2 indicates that coverage would take 2 days, and so on.
It’s important to remember, however, that a stock’s average daily trading volume is rarely exactly the same as that stock’s actual trading volume on any given day. And during a short squeeze, a stock’s trading volume can vary significantly from its average as news of the unexpected rally spreads and public interest in the stock piques.
In any case, even though days to cover is a crude estimate at best, the higher the ratio, the longer and more extreme of a short squeeze a stock is poised for should it start to rally.
