What is short selling and can retail investors make a buck doing it?

Short sellers are one of the most mysterious, but most powerful actors in the markets. They have been known to bring down entire companies, including some that have appeared to be perfect.

Just who are short sellers and how successful are they?

 

What is Short selling?

First, we must recap what is short-selling – what short-sellers do.

Short selling is a trading strategy that enables investors to benefit from price declines in a security. It involves borrowing shares of a security from a broker, selling those shares with the expectation that the price will fall, and then buying back the same number of shares when the price has declined in order to return them to the lender. Here’s how it works:

1. Borrow the Shares: The investor borrows shares of a stock from their broker, typically paying a fee for the borrowing arrangement.
2. Sell the Shares: The investor immediately sells the borrowed shares on the open market, generating cash from the sale.
3. Buy Back the Shares: At a later time, the investor buys back the shares they borrowed from the broker. If the price of the stock has fallen since the initial sale, the investor can buy back the shares at a lower price, thereby profiting from the difference.
4. Return the Shares: The investor returns the borrowed shares to the broker, closing out the short position.

 

Why is it done?

1. Speculation: Investors may short-sell stocks if they believe the price of the stock will decline in the future. By selling high and buying back low, they can profit from the difference.
2. Hedging: Short-selling can be used as a hedge against other long positions in a portfolio. For example, if an investor holds a portfolio of stocks and wants to protect against a market downturn, they may short-sell certain stocks to offset potential losses.
3. Arbitrage: Short-selling can be used in arbitrage strategies to exploit price differences between related securities or markets. 

 

Can short selling be profitable?

This strategy can be profitable if done correctly as the investor may be able to buy back their securities at a lower cost than what they initially sold them for. Short sellers typically speculate that the market for a particular security is overvalued or that an event such as an earnings report could result in a decline in its value.

They use this strategy because they are looking to capitalize on mispricing and potential catalysts that may lead to quick profits. Nevertheless, if prices rise rather than fall they suffer losses since they must buy back their shares at whatever market rate is available. In this sense, the potential loss is unlimited, unlike in ‘long trading’ where you cannot theoretically lose anymore than you invested in the first place.

 

Who are short sellers?

Short sellers are any investors that engage in short selling. However, the term is typically only applied to institutions that specialise in it. Short-sellers may target companies whose stocks have been overvalued and appear to be headed for a drop, or businesses that have recently released negative news that may lead to a decline in share prices. In some instances, they may even accuse the company of fraud.

By taking a position through short selling, short sellers are essentially betting against the market and hoping for an eventual drop in prices. Beyond taking individual positions, short sellers also publish reports outlining their assumptions, hoping that other investors follow their lead in shorting the stock or that they exit the stock if they hold it.

 

Can short sellers have an impact?

Yes they can – to the point of even bringing down the company. For example, in 2001, investor David Einhorn used a strategy of heavy short-selling to target the stock of Allied Capital Corp., a publicly traded business development company.

By using massive amounts of leverage and selling hundreds of millions of dollars worth of stock short over several months, Einhorn was able to push the share price down significantly and cause it to plummet by more than 50 percent. This caused immense losses for other investors who were holding the stock and had not anticipated such a sharp decline in its value.

 

Not so Blue Skies

A more recent and local example is Blue Sky Alternative Investments. In 1Q18, Glaucus claimed Blue Sky had overstated its fee-earning assets under management and that Blue Sky shares were over 75% over-valued. It published two reports and the second led to Blue Sky’s market value plunging by around $800m. The following year, the company fell into receivership.

Both examples are extreme ones, however. Although it is common for shares to drop, they don’t always last for long. The best example of a company that endured a short-term decline, but recovered is WiseTech (ASX:WTC), which was attacked in 2019. It fell by a third in three months, but is now up over 600% since then.

 

It is worth being aware of short sellers

Love or hate them, the fact is that short sellers can play a major role in influencing the share price of stocks due to their ability to affect market sentiment and impact prices through buying and selling activities as well as dividend payment obligations.

So, it may spell trouble for companies, but whether it is short-term or long-term will depend on whether or not their accusations are true. And unfortunately, outright short selling is not something retail investors can typicically do, other than with put options and CFD’s (Contracts for Difference). However, these instruments usually carry a relatively high fee for the broker, which makes them less interesting.

 

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