Short Selling

What Is Short Selling?

A trading or investment method known as short selling makes predictions about the price drop of a stock or other security. Only seasoned traders and investors should use this sophisticated approach.

Investors or portfolio managers may use short selling as a hedge against the downside risk of a long position in the same security or a comparable one, while traders may use it for speculation. Speculation is a sophisticated form of trading that entails a high potential risk. A more frequent transaction is hedging, which involves taking an opposite position to lessen risk exposure.

When a seller engages in short selling, they open a short position by borrowing shares, typically from a broker-dealer, with the intention of repurchasing them at a profit if the price falls. Because you cannot sell shares that do not exist, shares must be borrowed.

A trader who wants to liquidate a short position purchases the shares again on the open market, hopefully for a lower cost than they borrowed them for, and then returns them to the lender or broker. Any interest or commissions levied by the broker must be taken into consideration by the trader.

how does short selling work?

As mentioned earlier, short selling is borrowing an asset (e.g., company stock) from your broker and selling it. When the price of the security declines in the future, you would be able to profit by purchasing that asset again at a lower price and subsequently returning it to the broker. 

Taking a short position on a stock is essentially the opposite of the more common long position. A long position is where an investor buys a stock with the hopes of its value increasing over time.

Another way to look at this concept is that it still follows the rule of thumb in investing by buying low and selling high, with a key difference that short selling reverses the order by selling high and then buying low. 

Short selling is definitely a bearish tactic because you are looking to profit off the decline in the price of a company’s stock. Although the mechanics of this method is different from selling calls or buying puts, the idea is the same: you think the stock is overpriced.

However, shorting is a high-risk tactic, and it should only be done by investors who have a decent knowledge of market mechanisms. In fact, to take a short position against a company’s stock, investors would need to have a margin account instead of the standard cash account. 

You require a margin account because your broker is essentially lending you money when you short that stock. So you’d need to put up collateral of a certain percentage of the total value of your short position. This is called the initial margin, and it is fixed at 50% in the US. 

Example – How a Short Trade Plays Out

Let’s go over the mechanics of taking a short position or “betting against” a company to show how investors could profit from a decline in its price. For simplicity, let’s assume that there are no transaction costs, dividends paid, or interest rates involved. 

In addition, suppose that you are an analyst at WSO Inc analyzing a fake competitor’s stock, Corporate Finance Academy. 

The company is trading at around $10 per share. However, as an online education platform, you’ve read some of their articles, and you realize that most of them are inaccurate and outdated. Upper management has gotten lax and hasn’t realized that there are competitors on the horizon. 

The competition is expected to eat away Corporate Finance Academy’s market share, and because of this, you believe they are overvalued, and you expect its share price to decline to $5. 

You inform your boss that you are “betting against” the company and will short 2,000 shares. This is what happens: 

• You short 2,000 shares of Corporate Finance Academy, receiving $20,000 (2,000 shares * $10)
• After 6 months, their share price dropped to $4 (your analysis was conservative in the beginning)
• You decide to “cover your short position” by buying back the 2,000 shares from the market.
• You spend $8,000 (2,000 shares * $4) and subsequently return the 2,000 shares to your broker.
• You made a profit of $12,000 ($20,000 - $8,000). Good job! 

Essentially, this is the mechanics of shorting a stock. First, you believe that a company’s share price will go down, so you subsequently short it to profit off that price movement. 

Mechanisms like short selling are why investors can always profit from the market despite its conditions. But, of course, you have to be thorough in your analysis, and if your bet is correct, you’d be able to make big money. 

Even during the global financial crisis (GFC), where most people lost money, a select number of investors were able to profit from the mortgage-backed securities massively. This is because they thoroughly analyzed the real estate market and realized that there was a bubble. 

They subsequently shorted relevant stocks belonging to the banking and real estate sector. Eventually, the housing bubble affected these two sectors the most, leaving smart investors with a chunk load of money.

The Big “Short” 

So what happened during the financial crisis? The movie covered the 2008 financial crisis very well. It depicted the life of three groups of finance experts who analyzed the housing market roughly a year before the crisis occurred until the period after the day the crisis was announced. 

The idea was initially solid: commercial banks give home buyers mortgage loans (which you can think of as debt contracts) and subsequently sell those debt contracts to investment banks. 

Investment banks then packaged thousands of those mortgages into a fixed-income asset called a mortgage-backed security (MBS) and subsequently sold them to investors. Investors who bought those MBS were entitled to interest payments from the mortgage loans.

As long as the homeowners could pay their mortgage loans, investors would be able to receive their interest payments, and everyone would be happy. Even if homeowners couldn’t pay their mortgages, the bank could repossess the house and sell it to meet its interest obligations.

As a result, these MBS products were considered “risk-free” assets that guaranteed coupon payments because “who doesn’t pay their mortgages?” 

These MBS products contained thousands of mortgages, and if some failed, the house could still be repossessed for money. The MBS would only fail IF a large enough proportion of homeowners defaulted on their mortgages (which would result in many people being homeless).

These mortgage-backed securities were profitable and had great yields. Furthermore, because they were considered “riskless”, there was solid demand for them. Therefore, investment banks would be able to generate substantial brokerage fees from selling these products.

Unfortunately, these MBS essentially consisted of homeowners and their mortgage loans, BUT the market only had so many people capable of affording houses (because of how expensive housing is). 

Because of this, commercial banks started giving out more and more subprime loans. Investment banks began packaging less and less safe debt contracts into MBS, but due to diversification (literally thousands of mortgage loans), they were still considered “safe”. 

In the movie, Steve Eisman (Mark Baum) and others realized that mortgage-backed securities were not safe and decided to short the MBS, essentially betting against the housing market. This is because they believed the MBS were worthless and would default in the future.

So how did he shorten the housing market? He purchased credit default swaps (CDS). Credit default swaps are synonymous with insurance, where investors who purchase CDS are protected against the demise of the bonds. 

It means that in the event of a mortgage-backed security default (its value becomes worthless), the loss from that MBS is swapped from the bondholder to the insurer (hence the name credit default swap). 

Here’s the kicker: synonymous with insurance, premiums on CDS were cheap, while its payout was large because it was insuring a low-risk asset. 

This was because markets believed that it was extremely unlikely for mortgage-backed securities to default. Hence investors who wanted to protect themselves against this event would only be needed to pay low premiums, and they would deserve high payouts if it did happen. 

During the financial crisis, Steve Eisman’s hedge fund FrontPoint Partners more than doubled from $700 million to $1,500 million. This was when Bear Stearns and Lehman Brothers went into bankruptcy and collapsed. 

Short Selling important points

Some people might find the idea of shorting strange. How could investors sell something they do not own? However, there is some rationality behind the Securities and Exchange Commission (SEC) allowing market participants to take short positions. 

Here are some benefits of allowing investors to short stocks:

• Price efficiency - investors would be able to push stocks towards their true value and reduce bid-ask spreads
• Market liquidity - there would be an increase in money flow from this activity.
• Hedging tool - Investors afraid that their long position may suffer from an impending recession could protect their portfolio by taking a short position.
• Greater returns - investors would be taking on more risk, but this would allow them to amplify the potential returns on their portfolio. The greater return arises from the fact that you use leverage to generate returns. 

In general, short selling may seem like a great idea, but it is a controversial topic. Many people, including Elon Musk, are against short sellers. This is because they consider it predatory, where investors exploit market conditions and profit from the losses of others. 

Aside from the fact that many consider short-selling unethical, some factors can’t be ignored when you decide to bet against a company. Here are some disadvantages of short selling:

• Brokerage fees - people who short a company incur additional fees that you wouldn’t otherwise experience when simply buying stock. 
• Dividend losses - for the period you are shorting a company, you are entitled to pay out any dividends that the company announces. This is because you owe someone the number of shares that you shorted and any money that the company pays out. 
• Interest rates - you can think of short selling as taking out a loan (after all, you are trading on margin). Because of that, the amount of money you borrowed will be subjected to an interest rate until you decide to cover your position.
• Buy in risk - brokers can force you to cover your short before you’d ideally want to. This could result in you losing money even though your strategy was correct.

Let’s say you shorted Corporate Finance Academy at $10, and before it dropped to $4, the share price temporarily went up to $12. If your broker forces you to cover your position at that time, you’d have no choice but to bear that loss of $2 per share. 

Perhaps the biggest disadvantage of short selling is unlimited potential losses. What does this mean? 

Imagine that you buy 1,000 shares of Corporate Finance Academy at $10, implying an investment worth $10,000. At most, for this investment, you would lose $10,000 if its share price dropped to $0. 

However, the sky’s the limit regarding the share price - it could go up to infinity, and so could your profits. 

Since a short position takes the opposite side of a long position, its payout is also reversed. Therefore, your potential gains in this scenario are capped at $10,000 if the company’s share price drops to $0. 

However, if their share price increased to $100, you’d have to lose $90 per share.

Therefore, if their share price increased to infinity, your losses would be infinite. One real-life example (not infinite losses but heavy losses) would be regarding investors who didn’t believe in Tesla stock and decided to bet against this company in 2021. 

The investors betting against Tesla stock were wildly wrong. It is estimated that the total realized and unrealized losses from short-sellers betting against Tesla stock are over $14 billion. 

Around July 2020, Tesla announced that they were selling short shorts for $69.420 (no joke) to taunt the Tesla bears. This was after Tesla’s share price increased substantially from its historical value from its 2020 Q2 sales announcement, beating analysts’ expectations. 

Meme stock short squeeze 

If you thought that the losses on Tesla shorts were bad, wait until you read about the meme stocks short squeeze. This case study is 100% real, and it resulted in many hedge funds bleeding money, with even one hedge fund (White Square Capital) going bust. 

A short squeeze is when something like this happens: 

1. An investor opens a short position on a company (often a substantial amount)
2. Market conditions have caused that company’s share price to rise dramatically.
3. Investors are forced to close their short position because their broker has forced them to or due to margin calls.
4. Because the investor now has to cover their short, they must buy back the stock at an elevated price. However, because they are buying a substantial amount of stock to return to the broker, the surge in demand results in an even higher stock price! 
5. The investor is forced to sustain heavy losses due to the short squeeze. 

So how did many institutional investors lose money, and in which trade did they lose money? The main stock involved is GameStop (NYSE: GME). However, many other meme stocks included AMC, BlackBerry, Bed Bath & Beyond, etc.  

It all started on a Reddit subreddit page called r/WallStreetBets. Keith Gill, who goes by the name of “Roaring Kitty” on Youtube & Twitter, began to share his long position on GME, which included call options worth over $50k. 

This subreddit also found that the total number of GME shares shorted by multiple hedge funds was over 140% of GameStop’s public float. That meant that there were more shares shorted than there were available. 

It also implies that single shares of GME were essentially borrowed and subsequently sold twice. Naturally, this pissed many people off because it was believed to be a market manipulation case, with a predatory nature of driving a company’s stock to the ground.

From a risk standpoint, institutional investors’ total heavy short position indicates their heavy exposure to the stock. The Redditors realized that these institutions would sustain a distressing amount of losses if their bet was wrong and share prices increased.

So that was what they did. By 24th January 2021, GME closed at $325 per share. This increased by over 8,000% in a meager 6 months when GME closed around $4 in July. For reference, the S&P 500 grows at an estimated average of around 10% per annum.

The estimated losses for all short sellers on 29th January were around $20 billion. So, this entire fiasco really shone a light on the United State’s capital markets. 

This was because, for some mysterious reason, Robinhood halted the purchase of GME and other meme stocks on the 28th Jan. Other share trading platforms soon started doing the same thing. As a result, investors couldn’t buy meme stocks, but they could only sell their existing positions.

This halted share prices from increasing and only allowed them to fall. It really is a free market until institutional investors lose money. This ended up triggering over 40 class-action lawsuits against Robinhood. 

The moral of the story is that when you short a company, you are seriously exposing yourself to heavy losses no matter how low the probability of the company’s share price increasing is. So please ensure that you carry out the proper due diligence before betting against a company. 

Researched and authored by Jasper Lim | LinkedIn

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