Short interest is simply the number of shares of a company’s stock that has been shorted. When greater than 10% of a company’s shares have been shorted, the stock may become susceptible to a short squeeze. A short squeeze is when a stock moves to the upside is exaggerated driven by short sellers scrambling to buy the stock to cover their short position. This can increase the daily volatility of the stock. A high percentage of short interest usually means that many investors think the stock price is going to go down, and therefore the short thesis is well known. This is incredibly dangerous because when shorting a stock, you have unlimited downside, meaning a stock can keep going up. This is not true when you buy a stock, because the most you can lose is 100%.
An example of a short squeeze and the danger of shorting high short interest stocks:
Company XYZ sold 100 widgets last year at $10 a widget. A bunch of smart analysts have been studying the trends in widgets, and now predict the company to sell only 75 widgets next year, even though the management team of XYZ thinks they will sell 100 widgets again. The analyst community gets wind of this thesis and several large funds short XYZ. Now, XYZ reports its 1Q earnings and they report flat year over year sales of 25 widgets at $10 a widget, and all of a sudden the short thesis gets called into question. New investors who don’t have a position are watching XYZ and decide to start buying the stock – existing shareholders also are excited and start buying the stock, pushing the stock up 5%. As a short seller of the stock, when your thesis all of a sudden gets called into question, and you fear losing your shirt, you decide to buy XYZ stock and so does all of the other short sellers. Now you have a stampede of buyers trying to fit through a small door, which pushes the stock price up far beyond the typical reaction expected. The 5% increase can quickly become a 15% or more. This dynamic has been happening more and more as stock ideas become more crowded with the growing number of participants that short stocks.