Sorry to disappoint, but there’s nothing lascivious in that attention-grabbing headline. Today we look at how some investors bet against stock prices by selling shares they don’t own, and the bad things that happen when they are wrong.
Short selling is actually a critical element of an efficient price setting mechanism for financial assets. Modern financial theory assumes that investors can bet in favor of a stock by buying it, but must also be able to actively bet against a stock by shorting it. Think of a short sale as an “anti-buy”, a powerful signal to the market equal in magnitude but opposite in direction to a buy.
Here’s how it works. Suppose you are decidedly negative on Apple stock (perhaps you don’t have much faith in the rollout of the iCar). You wish to bet that Apple stock, currently selling for $100, will decline in value. You decide to initiate a short sale by contacting your broker and borrowing 100 shares of the stock. You then ask the broker to sell the stock and deposit the $10,000 proceeds into your margin account. That is the essence of a short sale: you sold shares of Apple that you did not own and kept the money in your account. Now the fun begins.
As long as your position is open, you must pay interest on the money in your account. That is because you still owe 100 shares and the broker will demand compensation for the loan. Furthermore, you must pass along any dividends you receive on the stock to the actual owner of the shares, most likely another customer of the broker that agreed to lend his shares for a small fee.
To close out your short position, you must buy 100 shares on the open market and return those shares to the broker, terminating the position. In order to profit, you must buy Apple shares sufficiently below $100 to cover your margin interest and transaction costs. So, if Apple falls to $60, you can buy 100 shares for $6,000, leaving you $4,000 to cover interest and commissions and leave you with a tidy net profit. Sweet.
Unless the stock moves the wrong way. Suppose Apple runs up to $150 per share. Now you are out $5,000 on top of your other costs. And it should be clear that the possible loss from shorting is theoretically unlimited: if the stock goes to $500, you are toast.
Most short sellers are sophisticated investors such as hedge funds that know the risk and can survive a large hit. When investors hold short positions on a stock that moves sharply higher, they typically scramble to unwind their positions to minimize losses. This is known as a “short squeeze,” as the shorts in a position are hammered with losses when the stock rallies. This occurred in the aftermath of the Brexit vote, as short sellers betting on a meltdown got squeezed in the ensuing market rally and had to cover their shorts.
Shorting is often used as a hedging technique to neutralize net exposure. A hedge fund might buy (go “long”) Ford and short GM in an effort to arbitrage a more favorable opinion on Ford while maintaining net zero exposure to the auto sector. In the hands of well-capitalized institutional players, short selling can be a valuable tool.
Clearly, however, it is not appropriate for most individual investors given the disproportionate risk. The ability to short serves a crucial role in promoting liquidity and expediting price discovery, but should be left to the pros. And next time you hear about someone’s shorts getting squeezed, you can smile knowingly.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co.