Typically, investors buy stocks with the hope that their share prices will rise. However, investors can also take the opposite approach by betting against a company's success. If you're convinced that a company's stock price has reached a peak and is about to decline, then you might try selling its stock short. The short ratio is the number of shorted shares divided by average daily trading volume, and it's used to gauge investor sentiment regarding a public company or the market as a whole. It's not to be confused with short interest, which is the number of tradable shares sold short divided by the number of shares trading on the market, also known as the float.

Stock Graph

IMAGE SOURCE: GETTY IMAGES.

Shorting stocks

Shorting a stock is the opposite of buying a stock. When you short a stock, you borrow shares from your broker in the hope that their price will fall. You can then sell the borrowed stock and collect your proceeds from the sale. Because you now owe your broker the number of shares you borrowed, you'll eventually have to purchase them. If you purchase the shares for a lower price than what you paid for them, then you can keep the difference between your sale and purchase prices. That's why short investors hope to see their positions decline in value.

The short ratio

Knowing how many shares of a stock have been shorted is a good indication of how investors view that stock. That's where the short ratio comes in handy. Also known as the "days to cover" ratio, the short ratio is calculated by dividing the number of shares sold short by the average daily trading volume. For example, if a company has 20 million shares sold short and an average trading volume of 5 million shares, then its short ratio would be four days (20 million / 5 million = 4 days).

The short ratio tells investors approximately how many days it would take short sellers to cover their positions if the price of a given stock were to increase. The higher the short ratio, the longer it will take to buy back those borrowed shares.

Using the short ratio

The short ratio can give you insight into how a company's stock price is likely to move. If a stock's short ratio is trending higher, then it may be a sign that investor sentiment in the company is souring, which is a warning for you to reevaluate your position and consider whether it's time to sell. A 2004 MIT and Harvard study found that stocks with the highest short interest ratios underperformed by 15% per year on average. Similarly, if a stock's short ratio is trending lower, then it could mean that investor sentiment in the company is improving, and the stock price has a good chance of going up. Keep in mind, however, that the short ratio on its own is not necessarily an accurate predictor of market direction.

Whether you're monitoring your current investments or keeping tabs on a stock you're interested in buying, the short ratio can provide some good insight as to where prices are going. Remember, you can make money in the stock market even when prices go down; you just have to be strategic and careful, as there is no limit to your potential losses on a short position.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.