What is the Short Interest Theory?
Short interest theory suggests that a high level of short interest indicates an imminent rise in the price of a stock.
How Does the Short Interest Theory Work?
Short interest theory posits that a high number of outstanding short positions on a stock predicts that a rise in the stock's price is likely to occur in the near future. The assumption is that as traders and investors begin to repurchase the stock in order to return the shares to the registered owners, the increasing demand places upward pressure on the price as traders repurchase owed shares.
For example, if short interest is high for stock XYZ, and XYZ is priced at $20, short interest theory states that the price will rise beyond $20 as traders covered their short positions (buy shares of XYZ) in order to close them out.
Why Does the Short Interest Theory Matter?
As short seller rush to repurchase shares of stock at the lowest possible price, the collective demand spike results in a fast-paced rise in the price of the stock. This is called a 'short squeeze.'