Short selling is a way to make money when a security price starts falling. When you expect a stock to fall in price, you borrow it from your broker and sell it. After sometimes buy it back in order to return it to your broker. The difference between the selling price and the buying price in this case is your capital gain. Short selling works if the price continues to fall. If the price does not fall or retraces after sometime, you can make a hefty loss on your short position. The loans that are taken in order to go short have to be repaid! If the lender asks them or the price goes up, the trader has to buy back shares in order to make the repayment. Now, the harder it becomes to get the right number of shares in the market, the more desperate the trader will become and the higher the prices can go. In case of futures or options, you don't need to borrow the security; you simply agree to sell the contract when you go short. Why do investors take a short position? The most obvious reason is that they are expecting the price to go down further. Short selling is also used for hedging purposes. In the case of stocks, you need to monitor the rate of short selling in order to gauge investor expectation as well as the future market direction. Now, NYSE and NASDAQ report the short interest in stocks listed with them. Now this data is released on monthly basis as the brokerage firms may need a while to report how many shares have been shorted and then report that data to the exchange. Now this number is known as the Short Interest Ratio. Short Interest Ratio is a very important number for short sellers as it can give important clues about the investor expectation to the short sellers. Short Interest Ratio reports the number of shares of a particular stock that has been shorted, the percentage change from the previous months, the average daily volume for that stock in the same month and the number of days of trading at the average volume that it would take to cover the short positions. An increase in the short interest ratio means that the investors are becoming nervous about the stock. Now, this number is not calculated frequently. What this means is that the trader cannot get a lot of information out of it. But still a high short interest ratio means that the stock prices will go high soon as the investors with short positions become desperate to buy it back. High Short Interest Ratios along with bullish indicators is an indication that prices are going to go up soon rather than down.
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