Q I noticed that some of my holdings have considerable short selling. What is short selling?
A Short sellers sell borrowed shares in hopes of buying the shares back at a lower price and pocketing the difference. Here’s how it works:
A short seller believes shares of XYZ Corp., trading around $50, will retreat. A short seller could borrow 50 shares from a broker and sell the stock in the open market for $2,500. If the price declines, the short seller can purchase the stock to “cover” the position. The profit is the difference between the price at which XYZ Corp. was sold and the price paid to buy it back, minus commissions and expenses for borrowing the stock.
Q What is the short ratio? How is it calculated?
A The short ratio indicates approximately how long it will take short sellers, in days, to cover their entire positions. The ratio is calculated by dividing the number of shares sold short (commonly called short interest) by a stock’s average daily trading volume.
For example, based on three-month average trading volume, Cooper Industries ($40; NYSE: CBE) has a short ratio of 2.9, meaning the number of shares sold short is equal to nearly three days of trading volume.
Q What are the implications of large short positions or high short ratios?
A The answer depends on your point of view. A short seller assumes a bearish stance, so outsized short selling could point to negative sentiment for a particular company.
However, a large short position could be the forerunner to a stock-price rally. That’s because a short position must eventually be covered (the borrowed shares must be returned to the lender), which signals potential pent-up demand. In a “short squeeze,” a heavily shorted stock starts to climb, pressuring short sellers to buy back the stock to prevent further losses. Ultimately, buying begets more buying, pushing a stock’s price higher.
To uncover potential short-squeeze plays, we screened for short interest that has trended higher in recent months, along with a short ratio above historical norms. The six companies in the table above made the cut. For three notable names — Manitowoc ($32; NYSE: MTW), Cooper Industries ($40; NYSE: CBE), and Wells Fargo ($24; NYSE: WFC).