This is a brief overview of the significance of short interest as a technical indicator for evaluating potential stock performance.
To begin, shorting itself is when short-sellers sell shares they don't own, in the expectation that the price of a stock will fall. It's a bet against market support for a stock's price. If the price goes up, they lose money. If it drops, they gain. Short sellers are obligated to purchase their short-sold shares at some future time, and must maintain substantial collateral until that obligation is covered. Until then, they are "short" the stock, with inverse market exposure to its rises and drops.
The percent of shares short, relative to the total number of shares outstanding, is a technical indicator called "short interest". Stocks with high levels of short interest can have some very special characteristics, depending on the specific details of the stock, and the company. What follows is a summary of the most interesting of those characteristics.
Short Squeeze Potential
The most well known characteristic of stocks with high short interest is the potential for a short squeeze. This can happen when lots of shorts try to cover their short positions at the same time. This happens because "covering" actually means buying the stock, which exerts upward pressure on the share price. Under normal circumstances, the market can absorb multiple shorts covering without too much of a ripple effect, but when short interest is extremely high, covering can cause a massive chain reaction: each cover forcing other shorts to do the same. The result can be a very rapid increase in the stock's price, and when that rapid increase happens, it's called a short squeeze.
Exhausted Shorting Pool
Other times, under conditions of high volume shorting, they simply "run out" of shares to short. Higher short interest is an indicator for the possibility of this phenomenon. When it happens, it renders shorts completely impotent to drive a stock's price down any further; it thereby eliminates most of the downward pressure on share price.
Another characteristic of stocks with high levels of short interest is price support. Because each short-seller is obligated to cover at some time, each is constantly shopping for the lowest price. As multiple shorts are willing to outbid each other at the floor, in order to cover before the others, they can have the cumulative effect of supporting a stock's price.
Protection from High Volume Shorting
Because institutional shorts use high volume shorting to drive stock prices down, high short interest can provide a degree of protection. That's for the reasons above, combined with the fact that high volume shorting increases short interest quickly, and high short interest is risky for shorts.
Short Interest as a Bearish Indicator
High short interest is often an indicator there's a strong bear case against a company. It's critical to understand the reason short interest accumulated, before deciding whether to invest.
Short Interest as Opportunity
High short interest does not always mean the bear case is airtight. In some cases, a stock with a favorable outlook can have high short interest, most especially after its outlook has changed in some positive way. Identifying these gems can be well worth your time, as the market reversal on these stocks can happen extremely fast.
Short interest is a useful indicator for evaluating the potential of a stock to climb dramatically, its level of price support, and its resistance to high volume shorting. However, it is also useful for identifying a history of bearish sentiment. Therefore, this indicator must not be used in a vacuum. Investors should seek to understand the rationale for bearish sentiment before deciding whether the short interest is a compelling reason to invest, or the symptom of a compelling reason to avoid investing. The specifics answer that question.