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Understanding Short Floats

S horts, floats, interest, ratios, closing, borrowing… the world of short selling is not for the faint of heart. If you want to venture into the realm of profiting off of dropping stock prices, you’ll have to get a handle on the vocabulary of short selling, including understanding short floats.

Takeaways:

  • Shorting stocks is an advanced investment strategy.
  • Floats represent a specific subset of a company’s shares.
  • Short floats are a percentage of the overall float.
  • Short interest ratios can help investors decide whether to execute a short.
  • Short squeezes occur when the market goes up instead of down.

Shorting a Stock

Image via Unsplash by Annie Spratt

Before we can get into short floats, we’ve got to start with shorting stocks. Stock shorting is an advanced trading strategy that relies on a stock’s value dropping. The lower the stock drops, the more money the investor stands to make. Here’s how it works:

  1. Borrow shares: The investor borrows shares (this is important — you can’t short with stock you own), usually from a broker-dealer.
  2. Sell the stock: Then, the investor sells the shares. At this point, the stock is in a ‘short float’ (more on that later), where the short is not yet closed out or covered.
  3. Buy back the stock: Next, the investor waits for the stock price to drop, and once it does, they purchase it back at a low price. This is called closing out.
  4. Return the stock: To complete the short, the investor returns the shares to the original owner and keeps the profit they made by selling high and buying low.

The Free Float

You’ll hear the word ‘float’ used as investors assess the value of stock or its viability for shorting. Two common types of floats are free floats and short floats. A float, or a free float, is the total number of tradable shares of a company’s stock. It’s an important number, since it’s used to determine metrics like short interest, short percentage of float, and short interest ratio.

The Short Float, or Short Interest

The short float is a percentage which evaluates the number of shorted shares in relation to the total number of floated shares. This metric is more commonly known as short interest. In theory, the maximum of a short is the same or equal to the free float, but in reality, this percentage rarely goes over 50%, though there have been examples historically where it’s happened. In most cases, a ‘high’ short interest is anything above 40%. If you see that number, look for a coming short.

It’s important to remember that the short float indicator refers to stocks which have sold short, but which investors have not yet covered or closed out. The New York Stock Exchange publishes short numbers twice a week for investors to use as they make buying and selling decisions.

Calculating the Short Interest, or Percentage of Float

To find the short percentage of a float, take the total number of shares shorted and divide it by the total amount of shares available for trade. This metric, despite what the name might imply, can be expressed as either a percentage or a number.

As an example, if 10 million shares are shorted with 30 million available floated shares, the short interest would be 10 million divided by 30 million. As a number, the short interest is 0.33, while as a percentage, the short interest equals 33%. The maximum possible number of shares investors could short would be 30 million, or the total free float.

Short Interest Ratio

The short interest ratio is another useful metric. To find it, take the short float, or the number of shares sold short, and divide it by the average daily volume for that company. This ratio is also known as the days-to-cover ratio, because it expresses how many days it’ll take short sellers to cover their positions if the stock heads back up in value.

For example, let’s say a company’s short float is 20 million shares, and the company’s average trading volume per day is 10 million shares. If we divide the short float of 20 million by the trading volume of 10 million, we discover that it would take two days for short sellers to cover their positions. Most traders try to avoid ratios of over eight days, as those present too much risk.

Using the Short Interest

Understanding the short float or short interest and corresponding metrics like short interest ratios can help you determine the potential risk and likelihood of payoff when considering a short. However, it’s important to use short interest carefully — it’s not great as a solo indicator. High short interest could mean a couple of things:

  • The company is in decline: The company could be in major decline with little hope of an uptick in value, making it a great short opportunity.
  • Investors anticipate a drop and a rebound: Conversely, the company could be facing a momentary drop in value with an anticipated increase in price.

Shorts are tricky. You can never be entirely sure what a high short interest indicates, so consider looking at other factors like company fundamentals and technical indicators to give you a clearer picture of the company’s overall health and where its stock valuation could be heading.

Understanding the News

Finding the right time to short depends primarily on the health of the company, which you can’t always quantify neatly in a metric or ratio. While these calculations can tell you how many people think the stock will decline, studying news reports which give qualitative information about the company, its leadership, product development, and other intelligence is the best way of determining whether or not a short is coming.

The Short Squeeze

A short squeeze is one of the biggest risks to taking a short position. A short squeeze takes place when a stock you have not yet covered or closed out moves up in value rather than down. In this case, short sellers must quickly close their positions to keep their loses to a minimum, but in doing so, they drive the price of the stock up higher.

Short squeezes are most common in small-cap companies, where there’s a small float to begin with, but mid-cap and large-cap companies are not immune to this phenomenon, either.

Short Selling Tips

In addition to keeping an eye on short floats and short interest ratios, keep these short selling tips in mind to help you have the best chance of success and the highest possible return on your investment:

Don’t just rely on valuation

You need to look at more than one metric, plus learn as much as you can about the qualitative value of the company, before you decide to short. Valuation can be a great tool, but it’s not the only tool you should use.

Stick to the low numbers

Attempting to short very expensive stocks could end in huge losses if the company’s value goes north. Instead, stick with lower value stocks so even if the market doesn’t work in your favor, you won’t lose a tremendous amount of money on your bet.

Watch for the sucker short

A sucker stock is one that has a huge, surprising rise in value. With a meteoric rise, lots of investors assume it has to drop and try to get their short moving. However, it could keep going up. Wait these out and don’t get in the game until the stock is on its way down.

Keep an eye on the moving average

You want your short to be below the 30-week moving average. It can be tempting to try to get in at what you think is the peak, but there are just no guarantees. Instead, watch the average and wait for it to drop.

Check the volume

Generally, you want to short less than 1% of the total daily volume. If a stock has a low volume, even if it looks like a good bet for a short, the risks might outweigh the potential returns. Many investors won’t short a stock with less than 500,000 shares traded daily.

Look for weakness

You’re going to want weakness in three areas — overall market, specific industry, and actual stock. Those situations are the short seller’s dream. If only one area is weak, you’re better off waiting. If two areas are weak, it could be worth considering, but take a look at other metrics, too.

Use a protective stop

A protective stop is a type of limit order that can help you avoid substantial losses on a failed short. For example, if you wanted to short a stock, but are worried about a reversal in trend, you could place a limit order for the maximum amount of money you’re willing to lose, so you’ll get the stock you need at the price you want. In the case of a short, whenever possible, you want your protective stop to break even.

Short on the way down

Lots of investors get greedy and want to maximize their profits by trying to time their short with the peak of the stock’s valuation. It rarely works. Instead, wait until the stock is actually headed down before pulling the short trigger. You may lose out on a few bucks, but it’s better than getting stuck with a stock that just keeps rising.

Use charting patterns

Charting patterns can help you identify opportune moments to short a stock. Useful patterns to look for include bearish reversal patterns like head and shoulders, evening star, shooting star, hanging man, and dark cloud cover.

Look out for seasonality

Short selling during the holidays is often a fool’s errand. Even though stock value can rise tremendously during this time, it’s hard to predict exactly when it’ll end. Wait for calmer, less seasonally affected times to play the shorts.

Find the hidden gems

Those big-name, highly public financial meltdowns tend to attract a crowd, and could result in a short squeeze. Instead, look for less-well-known company collapses to short.

Understanding short floats, using short interest, and calculating metrics like short interest ratios can go a long way in helping you identify successful shorts and pulling in a nice profit. However, it’s important you don’t solely rely on these numbers. Use other factors to help you determine the right moment to make your play.