The Short Ratio

Nov 30, 2007 2:29 PM

This week’s screen isn’t so much a screen, but rather a look at how using a market sentiment item can help find new stock picks. The item is called the “short ratio.”

The short ratio is the number of shares sold short (short interest or bets that the stock will go lower in price) divided by the average daily volume. This is also sometimes referred to as the "days to cover" ratio, because it tells approximately how many days it will take short-sellers to cover their positions if good news sends the price higher.

The higher the ratio, the longer it would take to buy back the “sold” (borrowed) shares. And in theory, the more short positions there are to cover, the stronger the short-covering rally would be.

Many people who use this indicator like to look for the number of “days to cover” to be higher than eight to 10 days. It’s generally believed that a short ratio of that size could prove difficult to cover, and therefore trigger a strong rally on any hint of an upswing. (My personal preference is to take that into consideration, but also compare it to the industry’s average ratio, and the stock’s own historical ratio.) And while I wouldn’t recommend using just the short ratio as the “be all, end all” of screening items, I do think it can be a great tool for helping define great opportunities.

For example: Sometimes when I’m looking for stocks that have been in a lengthy consolidation, I’ll look for those stocks with high short ratios.

Why?

Because consolidation ranges are basically areas of market indecision. Bets are being made by both bullish and bearish investors, so finding stocks that are going back and forth near their price highs with a growing short ratio shows that ever-increasing bets are being made on prices going lower.

However, if the stock breaks out to the upside, properly positioned bulls will more than likely add to their winnings, undecided traders will now be convinced to get long, and shorts will have to scramble to cover their bearish bets. This can be an explosive situation. This can also be used quite effectively for bottom fishing as well.

When a stock is getting battered, and pundits are wrangling over whether it’s the bottom or not, you should pay close attention to the short ratio. Of course, there has to be a reason for a stock to move higher, so seeing an improving fundamental outlook is important.

But when lopsided market sentiment seems to be at its worst (reflected in investors’ buying and selling), the short ratio can be just the thing to uncover extremes.

For example: For beaten-down stocks you can search for companies near their 52-week lows with increasing short ratios. Or better yet, look for short ratios above their average values, or even ones that are at (or near) their historical highs.

For stocks moving higher, try looking for historically high short ratios for stocks up 20 percent or more (new uptrend), or that have just rallied past an important moving average like the 50- or 200-day average. (Funds will often pile in at those points, so a large short ratio could propel the market significantly higher as huge buyers bid the market up, while panicky shorts chase it even higher just to get out.)

A screen I’m currently running however is not a bottom-picking screen. In fact, it’s looking for stocks in solid up-trends. The parameters to this week’s screen are:

Up 20 percent or greater over the last 12 weeks.
Trading within 10 percent of their 52-week high.
With upward earnings estimate revisions for the current quarter over the last four weeks.
And that have seen a month over month increase in their short ratio.
All of this is added to companies trading over $5.
And that have an average daily trading volume of at least 50,000 shares or more.

Here’s three of the companies that made the list this week (11/27/07):

AIRM   Air Methods Corp.
DM       Dolan Media Company
MTD    Mettler-Toledo International

Try using the short ratio in some of your current screens, and see if it doesn’t give you a greater edge and keener insight into what’s really happening in your stocks.

This item isn’t available in all screeners (especially the historical values and industry values), but it is available in the Research Wizard.

Remember, the key to successful screening is in discovering those screens that have produced profitable results in the past. And that’s exactly what you get with the powerful screening and back-testing ability of Research Wizard.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.