What is the short interest ratio?
We already talked about short interest, expressed as either the net number of shares sold short that are still outstanding (i.e. they have not yet been covered) or as a percentage of the company's float.
Short interest ratio (also known as days to cover) is a theoretical attempt to measure the magnitude of a potential short squeeze for the stock. It is the result of considering the total number of shares that are currently sold short, divided by the average daily trading volume for the stock over a certain period of time.
For example, let's look at Crocs Inc (ticker: CROX). Crocs Inc has 85.67 million shares outstanding and a float of 81.71 million shares. The total number of shares that were outstanding short positions (i.e. they have yet to be covered) were 8.59 million shares. With an average daily trading volume of 2.71 million shares over the last 3 months it would theoretically take 3.16 days for short sellers to cover all the shares that are currently sold short.
Similarly to the short interest, the short interest ratio is a good indication of market sentiment with respect to a certain stock. Coupled with the fact that it also considers the trading volume of a stock it is also a good indicator of potential short squeezes, which can be taken advantage of from the long side.
Keep in mind that short sellers, especially professional hedge fund managers are some of the savviest traders and investors that are out there in the market. Because of this, the fact that a stock has a high short interest ratio in itself does not necessarily mean that a short squeeze will materialize since oftentimes those shares have been sold short for valid reasons (negative prospects for the business, shares being overvalued, etc.). It is therefore, as usual, important that you carry out your own research before taking any position in the market and that you use these ratios as indicators but not as sole triggers for financial decisions.