What 'Short' Interest Says: Analyst's Toolkit

Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.

BOSTON (TheStreet) -- Shorting stocks, or betting on a decline, is considered by some to be reckless -- meddling, even. But for investors in it for the long haul, the amount of short interest is helpful because it's an indication of a company's value and its stock's possible direction.

To short a stock, a short seller must borrow shares from a broker and sell them in the market. To cover the short position, the short seller purchases the stock and returns it to the broker. Investors, who short stocks they think are overvalued, make a profit on the difference between the two prices.

The higher the short interest, the more people think the price is too high.

There are two key statistics to consider when evaluating short interest. (That information is available on TheStreet.com's company-profile tab. Here's General Electric, for example.) The first is the short ratio, which is the amount of shares shorted divided by the average daily volume of trading. That statistic shows how many days of trading it would take for the entire short interest to be covered. A high number indicates a lot of short interest or thin trading. High short ratios can lead to a so-called short squeeze, in which a large number of short sellers try to cover short positions at the same time, flooding the market with "buy" orders and artificially pushing up the price of the stock.

Atheros(ATHR Quote) is a good example of a stock with a high short ratio. With a ratio of 9, the network-equipment maker is far above competitor Broadcom(BRCM Quote), which has a ratio of 2.9. That suggests Atheros' current value is rich. Atheros' stock has risen 68% over three months, and Broadcom is up only 10% over the same period.