Understanding Short Selling

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Understanding Short Selling

What is Short Selling

Short selling is the sale of a security that the seller has borrowed. A short seller profits if a security’s price declines. In other words, the trader sells to open the position and expects to buy it back later at a lower price and will keep the difference as a gain. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically unlimited, short selling should only be done by experienced traders who are familiar with the risks.

BREAKING DOWN Short Selling

To open a short position in a stock, a short seller will borrow the shares. For most investors, the lender that is providing the shares is their broker. In order to open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. To close a short position, a trader buys the shares back from the market and returns them to the lender/broker.

The process of locating shares that can be borrowed and returning them at the end of the trade are handled behind the scenes by the broker. Opening and closing the trade can be done through the normal trading interface with most brokers.

Imagine a trader who believes that a stock, which is trading at $50, will decline in price. She borrows 100 shares and sells them. The trader is now “short” 100 shares since she sold something that she did not own in the first place. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $45. The trader decides to close the short position and buys 100 shares for $45 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $500: ($50-$45) X 100 Shares = $500.

Suppose the trader did not close out the short position at $45 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500 [($50-$65) X 100 Shares = -$1,500], since the shares were bought back at a significantly higher price.

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Short Sale Metrics

Two metrics used to track short selling activity on a stock are the Short Interest Ratio (SIR), or “short float,” and the Short Interest to Volume ratio, or “days to cover” ratio. The SIR measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. The short interest to volume ratio is the total shares held short divided by the average daily trading volume of the stock.

Both short-selling metrics help investors understand whether investor sentiment is becoming more bullish or bearish for a stock. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued. A high days to cover ratio is also a bearish indication for a stock.

For example, after oil prices declined in 2014, General Electric’s (GE) energy divisions began to drag on the performance of the entire company. The short interest ratio jumped from less than 1% to more than 3.5% in late 2015 as short sellers began anticipating a decline in the stock. By the middle of 2016, GE’s share price had topped out at $33 per share and began to decline. By late 2018, GE had fallen to $10 per share, which would have resulted in a profit of $23 per share to any short sellers lucky enough to short the stock near the top in July, 2016.

Short Squeeze

If a stock is very actively shorted with a high short float and days to cover ratio it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop where demand for the shares attracts more buyers, which pushes the stock higher, which causes more short-sellers to buy back or cover their positions.
Unexpected news events can initiate a short squeeze which may force short sellers to buy at any price to cover their margin requirements. For example, in October, 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze. In 2008, investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock. However, in a surprise announcement Porsche revealed that they had secretly acquired more than 70% of the company using derivatives, which triggered a massive feedback loop of short sellers buying shares to close their position.

Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn’t interested in selling, and another 70% was controlled by Porsche, so there were very few shares available on the market (float) to buy back. Essentially both the short interest and days to cover ratio had exploded higher overnight, which caused the stock to jump from the low €200’s to over €1,000.

A characteristic of a short squeeze is that they tend to fade quickly, and within several months Volkswagen’s stock had declined back into its normal range. This is an extreme example of a short squeeze but it helps illustrate the asymmetric risk of short selling. A trader who has bought stock can only lose 100% of their investment. However a trader who has shorted stock can lose much more than 100% of their original investment because there is no ceiling for a stock’s price.

Short Selling in Context

Sometimes short selling is criticized and short sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity to markets and can help prevent bad stocks from rising on hype and over-optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles (like the mortgage-backed security market prior to the 2008 financial crisis) are frequently difficult, or impossible, to short.

Short selling activity is a legitimate source of information about the demand for a stock and investor sentiment without which investors may be caught off-guard by negative fundamental trends or surprise news. One reason some investors may have concerns about short sellers are from rare but legitimately unethical practices employed by unethical speculators. Some investors have used short selling strategies and derivatives to artificially deflate prices and conduct “bear raids” on vulnerable stocks. Most forms of market manipulation like this are illegal in the U.S. but it still happens periodically.

Short Selling Summary

Short selling occurs when an investor borrows a security, sells it on the open market and expects to buy it back later at a cheaper price. Short sellers may be hoping to profit from the decline in price or their goal could be to hedge their risk in a related security or asset class. Short selling stocks requires a margin account and usually incurs interest charges based on the value of the stock that is held short.

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