Technically, short-selling (shorting) a stock is like borrowing the stock and selling them in the market.
You make money when the share price falls and you lose money when the share price rises. So, the effect is the opposite of buying the shares.
In order to do that, you have to borrow the share from existing share owners to sell. The borrow cost can be as low as 0.5% a year to more than 10% a year.
When you short a stock, if you want to flatten your position, it’s called “cover”. Covering your short position means you buy back the shares in the market and return the shares to the owners.
What’s the benefit of shorting?
Well, if you know that the share price is overvalued and will fall soon, you want to benefit from the falling share price. So, you short the shares. If the share price at $10 falls to $6, you earn 40% (before paying for the borrow cost).
Also, when you short the shares, e.g. worth $1m, you don’t really need to come out with $1m cash. On contrary, you may get $1m cash instead, which you could use to invest in other stocks. That’s how some hedge fund with capital of $1 billion could invest in stocks worth more than $1 billion. In shorting, you may be required by the broker to place a margin, say 20%. E.g. for shares worth $10m, you come out with $2m.
What’s the risk of shorting?
If the share price keeps rising, you will feel the pain. Extreme pain if the share price rises much higher than you expected. Theoretically, there is no limit to how much the share price can rise. The price can double in one year or one quarter or one month. See the earlier post on Penny Stock Saga (more than 10x increase in share price in 1.5 years).
So, the risk seems pretty high and can be unlimited. On top of that, you still have to pay the borrow cost. Also, you may be forced to cover the shares at the worst possible time (could be due to acquisition by other company at higher price). See the discussion on Citic Pacific below.
Spike in share price
Sometimes, why did the share price rise sharply in few minutes before the market closing time?
One possible cause is that some owners of the shares decided to take their shares back (recall) from the borrowers. So, those borrowers who short the shares are forced to buy their shares in the market (cover) to return the borrow. They may be given one day notice to cover the shares. If they can’t find other shares to borrow, they are forced to cover the shares immediately. See the example for Citic Pacific below.
On 27 March 2014, Citic Pacific announced that it would buy the assets of its state-owned parent company, Citic Group. New shares would be issued at $13.48 per share (6.48% higher than previous day’s closing price). This stock has quite heavy short selling interest and the stock borrow cost was quite high at 5% or more (can’t remember the exact figure as it’s re-rated several times). When the news broke, the share price rose sharply to as high as 31% over the previous day’s closing price to $16.54. I was watching the intraday price chart every second.
Why would it trade to $16.54 momentarily (22.7% higher than the newly issued share price)?
Partly because, there was stock borrow recall on that day. Several short sellers were forced to cover their shares because their stock loans were recalled by the original owners. Some hedge funds also have policy to cut their losses if the losses exceed certain dollar amount or percentage. Therefore, in an instant, they had to “buy the shares” in the market to cover their short positions. When several hedge funds rushing in to buy the shares to cover their short on that day, we saw a spike in the share price for a short period. It’s a bit irony, isn’t it? They buy the shares not because they think the price will go up, but because they are forced to cut their short selling position. When this short-covering squeeze (forced buying) was over, the market became more rational, and the share price fell back to closer to the newly issued price of 13.48.
Long vs Short
For long-only investors (those who buy only, not shorting), the most they could lose is 100% when the company they invested in go bankrupt. If the share price falls by 60%, they could hold on to it if they don’t need the money and still have confidence that the share price will rise back. They don’t have any additional costs to pay to hold on the shares. If the company pays dividend, then the investors can get dividends as consolation prize. The upside? The share price can double or triple or even more and you take all the gains.
For short sellers, they could lose more than 100% when the share price doubles. This can create lots of nervousness and liquidity issue because they may be required to place more money with the broker when their short positions have suffered so much losses. On top of that, if the stock borrow cost is high, say 5% a year, they’ll have to pay that borrow fee. If the company pays dividend, short sellers will have to pay these dividends to the original share owners from whom they borrowed the shares. Double/triple whammy. The upside? 100% return when the company goes bankrupt and you may get that sensation that everyone is losing money except you.
Still interested in shorting?
After knowing the risks of shorting, are you still interested in shorting? Value investors don’t short stocks. They look for undervalued stocks and buy to accumulate over time. Some hedge funds employs both buy and short strategy. Some focuses more on shorting strategy. Muddy Waters, for example, is well known to have shorted several companies.
I’m not saying that shorting is bad. You just have to know the risks involved. You can’t predict that other companies are interested to buy the companies that you are shorting at much higher price. When the acquisition news break, expect short sellers to lose 10-30% in a day. A stock can be overvalued at $100, but the market can be irrational and bids the price to $150. On the other hand, if the entire stock market is overheated, just like during internet bubble in 1999-2000, short sellers made tons of money when the crash happened, and long-only investors would have to suffer losses (paper losses at least if the companies are good ones).
If you see a stock is very overvalued and want to short it, remember the quote from John Maynard Keynes:
“The market can stay irrational longer than you can stay solvent.”
After considering the risks and if you still think that the rewards exceed the risks, then go ahead and good luck 🙂
Afterall, many investors made money from shorting (and many suffered losses from doing it too). I’m not sure if there is any reliable statistics which compare the gains and losses of short sellers. You apply the knowledge and skill that you are good at to make money in stock market. Many successful fund managers employ different investment strategies and buy different stocks and still make tons of money.