Short Interest vs. Free Float

When you expect a certain company's stock price to rise, it's easy to put your money where your mind is: just buy the stock and wait for it to go up. When you expect the price to drop, however, cashing in is more complicated. First, you have to borrow shares from your broker. Then you sell them. This is called "selling short." Then you wait for the share price to drop. When it does, you buy back the shares and return them to your broker. This is called "covering" your short. The difference between the price of the borrowed shares you sold and the replacement shares you bought is your profit. (Or, if you misjudged and the price went up, it's your loss.) "Short interest" is the total number of shares of a company stock that have been sold short but have not yet been covered.

Just about every stock is going to have some short interest. The prices of even the best stocks ride up and down over time, and there will always be some day trader somewhere wagering his kids' college fund on a dip. The key number to watch is the "short ratio," also called "days to cover." Take the short interest and divide it by the stock's average daily volume -- the number of shares that trade on an average day. For example, if short interest is 225,000 shares and the average daily volume is 150,000 shares, the short ratio is 1.5. It would take 1.5 days at current trading levels for all the short sellers to cover their positions. The higher the ratio, the more bearish the sentiment on the stock, meaning investors generally expect the price to fall. However, if that ratio gets too high, the stock can wind up in a "short squeeze." That's when short sellers all try to cover at the same time. With so many people trying to buy replacement shares, the price rises -- and the very people who had bet on the stock price falling end up forcing it to rise. There goes the kids' college fund.

In the U.S., you see the term "public float" or just "float" more often than "free float," but they mean the same thing: the number of shares of a company's stock that are in the hands of the investing public, available for trading. That doesn't mean those shares are actually for sale; it just means there's nothing preventing their owners from selling them. You calculate a company's free float by taking its "outstanding" shares -- that is, all the shares currently owned by all stockholders -- and subtracting the total number of "restricted shares." Those are shares held by company insiders, such as executives, directors and anyone who owns more than 10 percent of the stock. Restricted stock can be sold only under certain conditions, so it's not counted in the float.

Looking at the size of the free float relative to the number of outstanding shares can tell you who controls the company, and how much say "ordinary" shareholders like you might really have. Imagine a company with 500 million outstanding shares but a float of 200 million. The majority of the stock belongs to insiders, so they control the company. Yell at them all you want at the annual shareholders' meeting, but you and the other non-insiders are pretty powerless. The size of a stock's free float also gives you a sense of the potential volatility of its share price -- that is, how wildly the price may swing up or down. In general, the fewer shares available for trading, the more volatile the stock. Combine a small float with a large short interest, and things can really get interesting. When short sellers go to cover, the pool of shares they can buy from will be more limited. That can intensify the squeeze and turn winners into losers more quickly.