By SIMON CONSTABLE
Short sellers do things differently. Unlike most investors, they want to see the securities they've selected decline in value.
Specifically, they borrow stocks or bonds and sell them, hoping to buy them back later at a lower price for profit. The short-seller maxim is "sell high, buy low."
A high level of "short interest" generally indicates pessimism about a stock. Typically, short sellers expect earnings will fall in the future.
However, short interest also can open the door for a future rally, though it may be short-lived. "If individuals or institutions short a stock, eventually they are going to have to cover that short" and buy back the stock, says Hugh Johnson of Hugh Johnson Advisors in Albany, N.Y. In that sense, the level of short interest "can indicate the future demand for a particular stock."
The short-interest ratio indicates how many days, based on recent trading volume, it would take short sellers to close their positions. If that figure is high and short sellers get caught on the wrong side of a bet—say, the company beats profit forecasts—they may try to close their positions to limit the damage, fueling a rally in the stock.
But investors in exchange-traded funds should be cautious about using short-interest data to draw similar conclusions. Sometimes institutional investors short ETFs as a hedging strategy. They might short the SPDR S&P 500, which tracks the Standard & Poor's 500-stock index, and use the proceeds to buy a stock they think will outperform the overall market.
In that case, observing that the SPDR recently had a short-interest ratio of 2.2 days isn't that useful. The hedge could remain in place for a long time, and it tells you little about how the ETF itself will perform. In addition, securities firms can create more ETF shares to meet future demand.
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