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"Short-Selling" StocksThere are many factors to consider when searching for new growth stock ideas such as estimate revisions, PEG ratios, and earnings growth. However, it is also important to be on the look-out for potential red flags so you can avoid those big losers that can kill a portfolio’s return. One such pitfall is a high “short interest.” What is short interest and how can it be helpful to you?
SHORTING-DEFINED
First of all, it would help to define “selling short.” Essentially, short selling is the opposite of buying stocks - it's the selling of a security that the seller does not own, done so in the hope the price will fall. Basically, it is the reverse of “going long” or buying a stock with the hopes of selling it at a higher price for a profit. Quite simply, short sellers hope to profit from falling stock prices.
ARE SHORTERS ARE SMARTER?
Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. If a stock has a high short interest, many investors believe that the stock will fall.
One common perception is that short-sellers know something that the rest of investors don't. There is little actual evidence to prove whether this is true or if it is false. However, a high short interest ratio is a sign that you should do more research to make sure you fully understand the potential risks associated with the stock before you invest in it.
DON’T BE TEASED BY THE SQUEEZE
One reason many investors speculate in stocks with high short positions is the prospect of the “short squeeze.” A short squeeze occurs when short sellers are scrambling to replace their borrowed stock thereby increasing demand and decreasing supply, forcing prices up. Short squeezes tend to occur more often in smaller cap, aggressive growth stocks, which have a very small float (supply), but large caps are certainly not immune from this situation. Unfortunately, however, this is a very difficult phenomenon to predict. When it works out, you can make a ton of money as the stock explodes higher, but these occurrences are few and far between and usually not worth the risk.
WHY RISK IT?
A high short-interest stock should be approached for buying with extreme caution but not necessarily avoided at all cost. Short sellers (like all investors) aren't perfect and have been known to be wrong from time to time. However, there are over 10,000 stocks that are publicly traded in the United States, so there is bound to be one that meets your fundamental criteria, which does not have a bulging short interest. The logical question becomes, “why take the risk?”
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