Short interest can provide a gauge of a stock's susceptibility to a possible downturn or short-covering rally. It's also one of the most misunderstood statistics among traders and investors.

Each month, the New York Stock Exchange and the Nasdaq Stock Market report the short interest on all listed issues after compiling the short positions of their member brokerages. For example, let's say the brokerages collectively have 1 million shares long and 1.5 million shares short in XYZ Company as of Aug. 15. The stock trades on the Nasdaq Stock Market. So Nasdaq would report the 500,000 shares -- the aggregate naked short -- as the short interest in that particular stock.

You can look up monthly short interest for individual stocks yourself in such publications as Investor's Business Daily or Barron's. You can download a text file of the short interest on all Nasdaq stocks from the market's Downloadable Market Data. Then you can use spreadsheet or database software to search the stocks according to your desired parameters.

Short interest -- both for the general market as well as for individual stocks -- is commonly interpreted using what is called the short-interest ratio. The ratio is calculated by dividing the number of shares short by average daily volume.

Take our example of XYZ Company. Let's say XYZ's average daily volume for the month the short interest was reported stood at 250,000 shares. The short-interest ratio for that stock would be two days -- 500,000 shares short divided by average daily volume of 250,000 shares. XYZ has two days' worth of short interest to cover, assuming a speed limit set by the stock's average daily volume.

The New York Stock Exchange Short-Interest Ratio, a well-known contrarian indicator, works the same way. The ratio is calculated by dividing the total short interest of all New York stocks by the average daily volume on the exchange. The ratio is used as a contrary indicator with extreme high readings coinciding with potentially excessive bearishness.

As an aside, I glance at the NYSE Short-Interest Ratio, but I don't use it. As measures of overall market sentiment, short-selling yardsticks lost much of their effectiveness in the 1970s and '80s as options gained in popularity as an instrument for bearish plays.

In this lesson, I'll describe how you can use short interest to evaluate individual stocks that you may be considering for bearish plays, either by short selling the actual issue or buying put options.

While important, short interest is a secondary indicator. I would never short a stock solely on my reading of its short interest. For more on short-selling tactics, check out Dave Landry's lesson, "Shorting Stocks: The Art Of Playing Both Sides Of the Market," and Mark Boucher's lessons, "Reviewing The Art Of Short Selling" and "Using RS Lists to Aggressively Trade on Long and Short Sides."

In a short sale, a trader hopes to profit from an expected decline in a stock's share price. The trader borrows shares from his or her broker and sells them. If all goes according to plan, the stock subsequently falls in price, and the trader buys the stock back for less than the earlier sale price. Buying the stock back is called covering your short. The trader returns the shares to the brokerage, pocketing the price difference, minus interest and trading costs, as profit.

What if the stock rises in price? Then the trader has a paper loss in the stock which becomes a real loss once he or she covers the short.

Heavy Short Interest Can Be Bullish

So shares sold short represent shares that will eventually be bought back. As a result, very large short interest is a bullish sign for a stock, at least for the near term. If the stock starts to appreciate, shorts may have to cover. Their buying could drive the share price higher, forcing still more shorts to cover either to lock in diminishing profits or staunch growing losses. This is what's called a short-covering rally.

The classic short-covering rally is characterized by a sharp price increase on light volume, but short-covering rallies can occur on heavy trade, as well. As soon as market makers know they have the shorts on the ropes, they jack up the bids to see how much pain they can inflict. The media often dubs rallies short-covering rallies when nobody really knows what's going on. Often, it's impossible to tell whether short covering is actually behind an otherwise unexplained price advance.

The point here is a contrarian one. Many traders assume that very high levels of short interest is a bearish sign for a stock. In fact, it's the exact opposite. All that short interest represents stock that must eventually be bought back.

"Very high short interest typically means a stock is a long way from a top," notes Bryan Brown, principal of Spectrum Equity Services, an institutional adviser based in Beverly Hills, California. "Stocks don't top on high short interest unless there is something seriously wrong."

How much short interest is too much? There's no magic number, just rules of thumb. Let's say I had compiled a list of shortable stocks using a variety of technical and fundamental criteria. I would eliminate stocks with short-interest ratios showing more than seven days to cover.

Expanding Short Interest Can Be Bearish

Expansions in short interest in individual stocks are a bearish sign. Again, there are no magic numbers. But keep your eye out for increases from minimal short interest, say one to three days to cover in the prior month, to some multiple of that amount. The smart money tends to move in early on the short side. Once they get their positions on, they often feed bad news to the financial press.

Beyond seven days to cover, watch out for short-covering rallies. I would not be interested, for example, in a short-interest expansion from 10 days to 15. Yes, such a short-interest expansion could mean the stock is headed for real trouble. But at those levels, it won't take much to rattle the shorts and trigger a rally.

A bearish expansion of the short-interest ratio can occur in one of two ways. Obviously, more short selling can occurring relative to long positions, increasing the short interest in the stock.

Another tactic involves shorting against the box. Let's say a deep-pockets player establishes both long and short positions in a stock. There are a number of reasons for putting on a paired position. The market participant may have started with a long position and enjoyed a run-up in share price, then shorted the stock as a hedge. Or the market participant may be a bear.

In either case, the market participant decides to bet outright on a price decline in the stock. So the player sells the long position. Uncovering a big boxed position drives up the naked short interest. (By the way, notice how this tactic enables a bear to go net short without waiting for the uptick!)

Arithmetic Distortion

Every ratio, of course, consists of a numerator and a denominator. The short-interest ratio consists of short interest as the numerator and average daily volume as the denominator. So if you use short-interest figures, be aware that a decline in the denominator (volume) will inflate the ratio, assuming no offsetting decline in the numerator (short interest).

Let's go back to our example of XYZ stock. In August, Nasdaq reported XYZ had a short interest of 500,000 shares and average daily volume of 250,000. Imagine that in September, XYZ's short interest remained unchanged at 500,000 but average daily volume fell to 125,000. XYZ's short-interest ratio would swell to four days to cover. I would disregard the expansion as any indication of increased bearishness.

Hedging and Arbitrage

Not everyone shorts on a bearish forecast. A short position, for example, can hedge a long position during times of acquisitions. Short sales are also used in convertible arbitrage. "Somebody might short a stock and buy a convertible preferred in the same company," Brown said. "One might do that if one fears inherent risk in the equity but the yield on the convertible preferred looks particularly good, or the conversion premium is particularly attractive."

So once you've compiled a list of stocks with short-interest expansions with days to cover of less than seven, and you've ruled out ratio inflation due to denominator contraction, then check the wires for news on the stock to rule out the presence of M&A activity.

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