The Short Ratio

Zacks

This week's Screen looks at a market sentiment indicator called the 'Short Ratio' to find new stock picks.

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 8-10 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 and 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, or recent lows, 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 for example, 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 be used quite effectively for bottom fishing too.

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 this screen, I'm looking for stocks that have been beaten down more than the market over the last quarter, but that have recently popped back up more than the market over the last week, amid a high short ratio.

  • Relative % Price Change 12 weeks less than 0(Stocks that have underperformed the market over the last 12 weeks. And since the market was down in that period, these stocks were down more.)

  • Relative % Price Change 1 week greater than 0(Stocks that have outperformed the market over the last week. And since the market was up in that period, these stocks are up more.)

  • Projected One Year Growth Rate greater than X Industry Median(Companies with growth rates better than their industry.)

  • Short Ratio greater than 10(Greater than 10 days to cover.)

  • Current Short Ratio greater than Short Ratio 1 Month Ago(In other words, the short ratio has increased over the last month.)

  • Current Price greater than or equal to $5

  • Avg. Daily Volume greater than or equal to 100,000

Here are 5 of the companies that made the list this week (10/11/11):

BJRI BJ's Restaurants, Inc.CCOI Cogent Communications Group, Inc.FWRD Forward Air CorporationHIBB Hibbett Sports, Inc.PRIM Primoris Services Corporation

All of these stocks were beaten down more than the market in the last few months, but have bounced back more in the last week, and they still have large short ratios.

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.

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.

Disclosure: Performance information for Zacks' portfolios and strategies are available at: http://www.zacks.com/performance.

BJ'S RESTAURANT (BJRI): Free Stock Analysis ReportCOGENT COMM GRP (CCOI): Free Stock Analysis ReportHIBBET SPORTS (HIBB): Free Stock Analysis ReportFORWARD AIR CRP (FWRD): Free Stock Analysis ReportPRIMORIS SERVCS (PRIM): Free Stock Analysis ReportZacks Investment Research

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