As you travel along the learning curve from thinking about chicken soup when you hear the word "stock" to thinking about ownership portions in real businesses, you'll likely learn about "shorting." In a nutshell, shorting a stock involves reversing the order of the old adage to "buy low, sell high;" investors who short aim to sell high and then buy low.
Suppose you want to short Home Surgery Kits Co. (ticker: OUCHH). Your brokerage will "borrow" shares from an OUCHH shareholder's account and sell them for you at the current high price. The proceeds of the sale go into your account. Then, once the share price drops, you'll "cover" your short by buying shares on the market at a lower price to replace the ones you borrowed. If you shorted OUCHH at $35 and covered when it fell to $20, you made $15 per share (less commissions).
You can't short every stock, though. To be shorted, a stock needs to qualify as "marginable." That means investors can purchase shares on margin, with funds borrowed from their brokerages. Most stocks on the New York Stock Exchange are marginable, and many Nasdaq stocks also qualify, while stocks trading for less than $5 per share often do not.
Be aware of shorting
Most investors can go through their entire financial lives merrily ignoring shorting. There are good cases to be made against shorting -- though many people do make money engaging in it. So am I here to recommend it or slam it? Neither. Instead, I merely want to suggest that when you consider investing in a stock, you also consider the degree to which it's being shorted.
As an example, let's consider a little outfit that sells coffee and a few other things: Starbucks (NASDAQ:SBUX). When I recently typed its ticker into an online data provider that includes short interest, such as The Motley Fool's Quotes and Data area, I got the following info in for SBUX on the "Key Statistics" page, in the "Share Statistics" section:
Average Volume (3-month): 5,704,300
Average Volume (10-day): 4,563,260
Shares Outstanding: 764.1M
% Held by Insiders: 2.15%
% Held by Institutions: 69%
Shares Short (as of 10-Nov-05): 25.57M
Short Ratio (as of 10-Nov-05): 3.9
Short % of Float (as of 10-Nov-05): 3.4%
Shares Short (prior month): 27.21M
Let's zero in on the short data. The company has about 764 million shares outstanding, and about 26 million shares have been shorted. The "Short % of Float" figure tells us that 3.4% of the freely trading shares have been shorted. (The freely trading shares are referred to as the "float." To determine it, you take the total shares outstanding and subtract shares owned by insiders and major shareholders, plus some other restricted shares.)
The short ratio (or "days to cover" ratio) tells us how many days of average trading volume it would take to cover the current short interest. Most healthy stocks have short ratios well below 5, so Starbucks doesn't seem too extreme. To see some higher numbers, consider Advent Software (NASDAQ:ADVS), with a short ratio of 9.8 and 5.8% of float shorted. For an even more extreme example, look at the recent short ratio of legal service membership network Prepaid Legal (NYSE:PPD): 86.3 days! The percentage of float shorted? 33%. Yowza.
It's not just high-flying, much-discussed stocks that end up with significant short interest. Humble little firms such as Motley Fool Income Investor pick Tupperware (NYSE:TUP) can be short-heavy, too. Its recent short ratio was 8.2, with 5.3% of float shorted.
Interpreting short interest
So what can investors make of such information? Well, one basic approach is to compare a stock's numbers with those of its competitors. General Motors (NYSE:GM) recently had a short ratio of 5.2, compared with 4.4 for Ford (NYSE:F). Its percentage of float shorted was 12%, vs. 4.4% for Ford. On this basis alone, it looks like investors have more confidence in Ford stock than GM stock.
It's also useful to note whether the number of shares shorted is rising or falling. For GM and Ford, the number was rising, suggesting flagging support for both. If you're considering investing in a stock with high short interest and/or rising short interest, you'd do well to investigate and see what's going on.
Squeezing gains
Here's another concept to understand: the "short squeeze." Let's go back to the Home Surgery Kits Co. Imagine that it is heavily shorted because many investors think that it's an unhealthy company, headed south. But then it reports solid quarterly earnings and announces some big new deals. All of a sudden, its future looks less grim. The stock starts to rise as some investors pile in. But as it rises, the short sellers are losing money -- at least on paper. They find themselves with two options: They can wait it out, expecting the stock to eventually drop significantly. But while they wait, it may still keep rising, putting them deeper and deeper in the red. Alternatively, they can quit while they're not any further behind, by covering their positions. They do so by buying shares on the open market to replace the ones they borrowed and sold. And what happens when they buy those shares? Yup -- the stock price rises a bit more on increased demand.
Do you see where this is going? It becomes a bit of a vicious circle. As some short-sellers cover and buy shares, the share price rises, causing more short-sellers to cover, and the share price rises even more. Who stands to do well during this episode? Those who are "long" on the stock -- the current shareholders who have been patiently waiting for the stock to rise.
Finding candidates
So when you're investigating a company, consider looking at its short interest. If you're attracted to the idea of bucking the crowd of naysayers, you can find some small, compelling companies recommended for investment in our Motley Fool Rule Breakers and Motley Fool Hidden Gems newsletters. One company that has been recommended in both has a short ratio of nearly 16, and 25% of its float shorted. Last time I checked, it had appreciated 33% since being recommended in one of the newsletters, and nearly 40% since being recommended in the other. Will a short squeeze help investors in this stock make even more money? Only time will tell.
Our analysts often find very promising companies among those reviled by many investors. Rich Smith explained, for example, how he has high hopes for Hidden Gems recommendation Select Comfort (NASDAQ:SCSS), despite 14% of its float being shorted.
This is a great time to give one or more of our newsletter services a whirl. We're offering free trials that permit you to peek at long lists of recommended stocks and funds, among many other things. Check our picks out and see for yourself how well they're doing.
Keep learning
Learn more about shorting in these articles:
Selena Maranjian 's favorite discussion boards include Book Club , The Eclectic Library and Card & Board Games. She owns shares of no stocks mentioned in this article, and has shorted no stocks. Formore about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.
