The Short Interest Theory

The short interest theory generally states a large short interest will lead to a rise in the price of a given stock. Short interest is a percentage that describes the total number of shares of any given security that have been sold short, in a specific period of time. Every security has a short interest measure, and the measure is typically very small. When this measure rises, though, it can indicate there is going to be a large purchase of the security in the near future.

Measuring Short Interest

Short interest is typically expressed as a percentage, and it is common to see that percentage huddle on the low end of the scale. For example, if a security is showing 2 percent short interest, analysts are telling you 2 percent of the outstanding shares in the security are held in a short position. There is nothing inherently good or bad about having a large or small short interest. However, it is an indicator of what investors must do to cover their position in the end. Whenever a security is held short, it must eventually be covered through a purchase.

Short Interest Theory

In the example above, 2 percent of the security's shares must be covered through a purchase. Imagine if the percentage was 5 percent or even 10 percent. In this case, the short positions needing covered are fairly high, and this could lead to a large purchase of the security. This would drive the price up, at least temporarily. The theory is not a measure of how long the price will stay high or even how high it will climb. Generally speaking, short interest theory is only a predictor of the fact shares must be purchased, but it falls short of predicting the ultimate affect this will have on the security as a whole.

Using Short Interest Theory

Short interest theory is one method you can use to estimate why the fluctuations in a security's price are occurring. For example, if Security A's price rises 2 percent, you may believe the price has broken a ceiling and will continue in an upward trend. This could lead you to purchase shares in Security A. However, if you also notice it is coming down from a very high period of short interest, you will be cautioned to think twice. You may be seeing a temporary rise in price because of the high amount of short sale activity on the security, not because it is truly rising through a previous boundary. 

Alternative Theories

Short interest theory is just one narrow peak at a security's performance in a limited period of time. You may consider using this measure along with trends such as average growth to determine if you are seeing the security respond to a short interest reaction or actually viewing something much larger. Many analysts prefer to stay away from these theories and models because they are often in conflict with each other. Further, trading based on short interest would require a high degree of vigilance and a large volume of trading, both of which can be costly.

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