Short Selling: Controversial Finance
With Deliveroo’s recent IPO being dubbed ‘the worst in history’, short sellers were blamed for the food delivery business’s atrocious start to life on the open market. (1) Not for the first time this year, short sellers have experienced a significant backlash on their investing technique, with the GameStop short squeeze in January 2021 making headlines globally.
The general premise of short selling (commonly referred to as ‘shorting’) involves an investor borrowing a security, and then selling it on the market. The intention of shorting is to buy the same security back at a later date at a lower price. Whilst this description certainly holds, it is useful to look at the detail to fully understand what short selling is and why it happens.
The motivation behind short selling begins with an investor who predicts that the price of a certain security (stocks, bonds, currencies etc.) is going to go down. This can be in the short run, the long run or anything in between but the pivotal point to note here is that the stock is expected to go down in value. In an attempt to profit from this downward movement, the investor will take a ‘short’ position. They will contact their broker and ask to borrow a set amount of this speculated security. Within this request, there will be terms and conditions relating to the fees and duration that come with borrowing the security. Usually, fees are paid annually and average around 0.30% of the loaned securities value. (2) Once the investor has received the securities loaned, they will sell them on the market. Providing that the investor’s prediction was correct, the price of the security will fall. The investor will then hope to buy the same quantity of securities at the lower price to return to the broker. Once the securities have been returned to the broker, the short selling process is complete. The difference between the price that the investor sold the shares and what they later repurchased them for is the profit made on the trade.
What is Short Selling?
The general premise of short selling (commonly referred to as ‘shorting’) involves an investor borrowing a security, and then selling it on the market. The intention of shorting is to buy the same security back at a later date at a lower price. Whilst this description certainly holds, it is useful to look at the detail to fully understand what short selling is and why it happens.
The motivation behind short selling begins with an investor who predicts that the price of a certain security (stocks, bonds, currencies etc.) is going to go down. This can be in the short run, the long run or anything in between but the pivotal point to note here is that the stock is expected to go down in value. In an attempt to profit from this downward movement, the investor will take a ‘short’ position. They will contact their broker and ask to borrow a set amount of this speculated security. Within this request, there will be terms and conditions relating to the fees and duration that come with borrowing the security. Usually, fees are paid annually and average around 0.30% of the loaned securities value. (2) Once the investor has received the securities loaned, they will sell them on the market. Providing that the investor’s prediction was correct, the price of the security will fall. The investor will then hope to buy the same quantity of securities at the lower price to return to the broker. Once the securities have been returned to the broker, the short selling process is complete. The difference between the price that the investor sold the shares and what they later repurchased them for is the profit made on the trade.
When short selling can go wrong
Whilst all is well when the price of the chosen security to short sell decreases, if the price of the security increases the investor is in big trouble. In the event of a price increase, the investor would have to buy back the security at a higher price, making a loss. In the event that many investors have made the same error in shorting a security that actually increases, a ‘short squeeze’ can occur. This is when investors scramble to buy securities that they’ve attempted to short so that they can minimise their losses. The huge upturn in demand for the securities puts upward pressure on the price making it even more costly for investors who are unable to buy the securities that they owe.
The recent GameStop market mania and its impact on those shorting the video game retailer’s stock is an excellent case study of what can go wrong. Melvin Capital experienced a $4.5bn loss in assets as a result of a sharp increase (more than 1,550%) in the price of GameStop shares. (3) The US hedge fund had taken a short position on GameStop since 2014 due to consumer preferences changing to online shopping. (4) It was not just Melvin Capital who suffered severe losses. Many other GameStop short sellers suffered as a result and have pushed the risk management of these firms to the forefront of their investing policy going forward.(5)
A common question regarding Short Selling
A question which may be raised when attempting to understand short selling is: why would a broker loan out a security if it is expected to decrease in value? There are multiple reasons for this. Firstly, nothing in the financial markets is certain which can be proven with countless examples of random volatility and market interruptions. The broker could therefore be hedging a bet against the investor, although there is much more to it than just that. The broker receives fees (similar to interest on a credit loan) which sweeten the deal of lending out part of a portfolio. A significant driver of this broker loan is a mismatch of time periods between those wanting to borrow securities and those who have securities to lend. If a broker is acting on behalf of an individual who is looking to keep their investments for 30+ years, price decreases in the short-term are likely to make a minimal amount of difference to the long-term returns of the individual. Consequently, what may be thought of as a dip in the short-term, is relatively meaningless in the long term and so there is more of an incentive to loan out the securities. Henceforth, there are many incentives for brokers to loan out securities to those wishing to sell short.
Why is short selling a controversial technique?
The previously mentioned GameStop hysteria did not only highlight the consequences of what can happen when a short selling position goes wrong, but also brought into question the morality of short selling. Whilst some were certainly investing for profit, other retail investors are thought to have invested in GameStop to send a message to Wall Street and hedge funds that shorting a stock is wrong. They argue that short-selling hedge funds bet against growth and force the prices of stocks down, which can lead to severe financial trouble for the shorted company. (6)
With that said, shorting has been around for hundreds of years and there is an abundance of evidence in favour of its use in financial markets. (7) Arguably, short selling makes markets more efficient by implicitly repricing securities back to their fair value. (8) It could be said that without this repricing mechanism, prices would remain artificially high until finally being caught on to, during which there would be an enormous sell-off. Thus, short selling acts as a liquidity supplier to the markets and, as evidence suggests, makes them more efficient. (9) Whilst it is certainly a contemporary topic of debate, there are some clear advantages to short selling which arguably go beyond the questions of its morality.
A Notable Example
There are numerous incredibly famous examples of short selling and the mass of profit that can be accrued when investor analysis is correct. Whilst Hollywood conveniently titled it ‘The Big Short’, the actions of various hedge fund managers at the tip of the US housing market collapse in 2007 gained the firms involved a gargantuan profit. The likes of Michael Burry, a stock market investor at Scion Capital, recognised inconsistencies in mortgage-backed securities. (10) Burry, alongside a relatively minute number of others, created a financial instrument which would enable him to short the housing market. (11) At the time, this was seen as financial suicide. A few years down the line and Burry has made $100million for himself and $700million for Scion Capital. If the numbers alone do not emphasise how wealthy the correct shorting of a security can make you, perhaps the fact that there is a Hollywood blockbuster depicting it will.
Although controversial, short selling will continue to be one of the most prevalent and important techniques used in financial markets by investors globally. With that said, heightened questioning of the morality of such a method could lead to greater retaliation amongst short selling-phobics. Users of the technique will be keen to avoid the disastrous consequences of said retaliation, such as those experienced in the GameStop short squeeze.
