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How do you use the short ratio and percentage-of-float short to gauge the possibility of a short squeeze? Thanks, E.R.
Short-selling is pretty much a backward form of investing.
Instead of buying a stock with the intent of selling it at a higher price, you borrow a stock (through your broker) and immediately sell it.
If the stock falls to your target, you then buy it at the lower price and return the shares to their rightful owner (probably through your broker) for a nice profit.
But watch out! There's danger involved.
While there's no limit to shorting a stock -- other than the limits on your own ability to tolerate a loss -- there's always the possibility that the owners of the stock could ask that the shares be returned immediately.
When they're orchestrated en masse, these so-called "buy-ins" are considered a short squeeze. They cause the stock's price to rapidly rise.
One way to assess whether a stock is heavily shorted is by viewing the magnitude of its short ratio.
The short ratio, or short-interest ratio, is the number of a company's outstanding shares that are sold short divided by the average daily trading volume.
Generally speaking, the higher the short ratio, the greater the pessimism about a stock. The ratio is also referred to as the "days-to-cover ratio" because it shows how many days it will take short-sellers to cover their positions.
It should be noted that some contrarian investors view the short ratio in reverse.
In their opinion, a high short ratio indicates a bullish outlook for a stock because it means a large number of short-sellers will be forced to cover their sale at some point, perhaps forcing a squeeze.
Those who take the contrarian approach are usually bullish when the short-interest ratio approaches 5 -- because it would take a long time to buy back those shares -- and bearish if it declines toward 3.
Short squeezes are more likely to occur in stocks with small market capitalization and small floats.
In general, if the percentage of shares sold short relative to a stock's float reaches 5% or higher, then the stock becomes increasingly susceptible to a short squeeze.