Stock Question - Short Selling

Factual Questions
1

Having a company I own stock in just go Chapter 11 (topic of another stock thread) has been educational. A lot of folks are stating that one of the reasons this company went belly up is that there was a large short position on this stock, and bad news about the company released at just the right time drove the price down hard and fast, allowing the shorts on the stock rake it in. This brings me to my question.

Why is shorting a stock legal? To me, shorting a stock is basically gambling, and the urge to manipulate the market with negative news would be difficult to ignore. I know the SEC is out there watching, but why allow the practice in the first place? Isn’t buying and selling stock on the open market enough? Maybe I’m missing something here, so if someone can explain to me the reasons to allow shorting I would appreciate it.

Thanks

2

In essense it’s about liquidity.

Shorting is just the mirror image of ramping/pump & dump manipulation on the longside. However people tend to react faster and more strongly to negative than positive news.

BTW, I don’t know which stock you are refering to but I think it’s probably in Chapter 11 because the shorters assessment of the company were right, not that they were in the market.

3

Woolly,

Can you explain in layman’s terms? To me, it seems odd that a brokerage would in essence “loan” me a stock at a certain price, with the promise that I would pay back that loan at a predefined date. I would think that if I borrowed enough, and the stock price went down enough, I hit the jackpot. And if I had some bad news about the company, shorted the stock, and released the news, I win.

The company is Winstar, and after everything came out, the shorts were indeed correct. However, it seemed that things snowballed because of panic selling. It didn’t take a genius to figure out this company was leveraged to the max… hell, even after it began its death spiral, brokerage houses were still calling it a strong buy. (They must have been trying to get out themselves.)

4

Your outline sounds ok to me!

As to why, well its usually about risk management. They’ll loan it to you because they think you’re wrong.

Say “they” are holding a stock with rumours that might fall. They could cash out totally, but it might go the other way. So they hedge their bets and decide to lighten. Then along comes a punter who wants stock to short.

They check their analysis and if they’re happy with their exposure they’ll lend out the stock. (If they suspect the short is onto something, they sell)

The short takes the risk and is paying them commission/brokerage/fees to do what they were going to do anyway. It’s money for jam.

BTW, I’m just an Aussie wood duck and I’ve never been inclined to short. I’ve go an outline on “how to” short in our markets somewhere, if you are interested.

5

Shorting a stock is indeed a gamble, but it does have its uses. If, for instance, you were sure a stock was going to tank, then you can make money.

Note that short sellers don’t actually affect the price of the stock; they just benefit when it goes down. When they short the stock, they are selling it at the current price. If that price doesn’t go down, they can’t do anything (legally) to make it do so.

In the case you mentioned, it wasn’t the short sellers that caused the problem with the stock; it was the panic sellers. Those who were short just waited while everyone else dumped their shares.

6

In fact, a large number of shorts is likely to temporarily elevate the price of a stock if something happens which triggers a lot of them to want to cover at once. This can either be a dramatic drop, causing a lot of the short positions to say “finally …” and rush to take their profits, or a big jump, causing the shorts who’ve hit the upside limit they set for themselves to cut their losses and get out. Called a “short squeeze”. You customarily see it applied to the latter case, but the term really applies to any situation in which demand is run up by a large number of shorts wishing to cover.

For this reason, one of the important things to consider when shorting is how many people have already shorted the thing. Often, this is usefully expressed as a “days to cover” or “short ratio” which is the number of days at average volume it would take to cover all the short positions. If it’s too high, too damn many people have already shorted the puppy.

7

He who sells what isn’t his’n
Buys it back or goes to prison.

8

There are many legitimate uses of a short position. For example, you can short a stock as a hedging play.

Real life example: My husband had an interest in a limited partnership that owned a large number of shares in a small internet company. Well, the internet company was bought out by a big internet company, and the value of the shares more than doubled.

The acquiring company was a typical internet bubble company, and my husband thought it was due to crash at any moment. But he couldn’t cash out since the limited partnership only allowed redemtions once a year, and the general partner would not listen to reason.

So, my husband shorted the stock, which fell by more than 70% last time we checked. So, the loss in value of my husband’s limited partnership was offset by the proceeds from the short sale.

This is known as “selling short against the box.”

While it is true that many unscrupulous short-sellers slander companies, the flip side (as was pointed out above) is that many unscrupulous shorts overhype stocks.

Note also that short-selling tends to make the price of a stock go down at the time of the short sale, and up at the time of the covering purchase. This is a simple result of supply and demand. There is nothing inherently wrong in this – if you think that the shorts have things wrong, just buy the stock from them - they are letting you have it cheaper.

Although I’m sure it happens that unscrupulous shorts badmouth a company into bankruptcy, I think it’s a lot more common given that shorts are blamed for the collapse of a company that didn’t have a workable business model or was the weakest in an overcrowded field of competitors.

One last comment: You characterize short-selling as “basically gambling.” I think it’s fair to say that going long in tech in the past couple years was also “basically gambling.” Unfortunately, your gamble didn’t pay off.
My husband made a ton of money from the whole bubble, but I have no illusions that his gain wasn’t at the expense of someone else who wasn’t so lucky.

9

Oops - that should have been “many unscrupulous LONGS overhype stocks”

10

Your broker makes money on your trades whether or not you actually do. Of course, you should be advised of the best course of action for your investment objectives (and an account whose investment objective is not speculation should not be allowed to short), but commission is charged on buy, sell, and, of course, short sale trades.

Also remember your broker has little or no exposure to loss on your short sale. When an account sells short, that trade must still be settled (the shares must be delivered to the buyer), so your broker will borrow shares from another broker to make the delivery if he does not have excess shares on hand. If the broker lending those shares asks for their return, the short customer is liable for their replacement should his broker be unable to borrow more shares from someone else.

There are many risks involved, and, sadly, many investors (and brokers for that matter) who do not completely understand the process.

11

All investment bankers will tell you that short selling is a very legitimate hedging instrument. Which is true although it seems like a lot more people go short in an outright bet that the market is going to fall than they do to hedge. Another way of looking at it is that an investor can profit when the market goes down as well as up. If you can only buy or go long, you only make money when the market goes up.

Short selling is also used quite extensively by arbitrage traders who are a) hedging a position or b) creating a synthetic option. For example, you can go long a call option or create a synthetic call option by a combination of being long the stock and owing a put option. Arbitrage traders take advantage of the mispricings in the market to create their position out of whatever is cheapest.

Now one thing I do want to point out is that stocks are a zero sum game. One party makes money and the other loses. For every share that is shorted, there is a share that has been purchased or goes long. Stocks do not go down because “there are more sellers than buyers.” That is patently incorrect. The price of stocks go down because the price where both buyers and sellers can agree on has gone down.

autumn wind chick also correctly pointed out that at some point the short position has to be unwound, or in layman’s terms you have to buy stock and then return it to whoever you borrowed it from. options are a little different but let’s not get that complicated here. That means all those short sellers then become buyers at some point.

“Squeezing out the shorts” is also something that certain hedge funds or investment banks try to do. If there is a very large number of short positions, especially in a stock with low liquidity, a trader with really big heuvo’s can aggressively buy the stock to push up the price. If the price rises above the short selling price, then all the people who have gone short are losing money. Their brokers may demand that they up their margin, or the brokers may automatically buy back the short stock, or the investor may want to cut loss, all of which means buying the stock. Suddenly demand for stock becomes huge and the supply of sellers is low, the price goes up…a lot. In turn causing more people that are short to cover their positions, and the price goes up higher.

going long, you’re downside is limited to your initial investment. Going short, you have theoretically unlimited downside as a stock price can go to infinity.

12

One thing I don’t quite understand is how hedging is more useful than simply not trading in a stock. After all, if I buy 100 shares of XYZ and short 100 shares of XYZ at the same time, I’ve limited my liability to zero, but I’ve also removed any possible benefit I can get from changes in the stock price. If I go long and short on different amounts, I’ve simply done the equivalent of investing the difference (i.e. buy 100, short 80 is equivalent to buy 20, short 0).

Someone tell me how this makes me money.

13

Galt, you would be right to say that it makes no sense to go long and short at the same time in the same stock. But short-selling can be useful if the timing is different or if the stocks are different.

An example:

Let’s suppose that you believe Southwest Airlines is a great company and is undervalued by the stock market. You want to invest in them, but you are worried that the global economic slowdown will cut into their revenues and make their stock go down even though they’re such a great company.

In this situation, you might go long on Southwest Airlines and go short on United Airlines. In effect, you are betting that in the case of economic slowdown, Southwest won’t be hurt as much as United.

Another example occurs when you already have a long position in a stock that you can’t close out but want to. For example, you may own the long position indirectly through an investment fund that lets you cash out only once a year.

14

Another question: what happens if you short a company that goes out of business (besides the obvious patting of oneself on the back)? Once the stock is gone, you can never buy those shares to cover what you borrowed. Do the lenders simply say “well, it’s worthless, so we’ll consider it paid back”, or does it hang in limbo, with you forever owing someone 100 shares of XYZ valued at 0?

I imagine it’s the former, but I’m curious as to the mechanics of it. In general, I get really confused about the details of stocks dying (and sometimes about splitting). A couple years ago, I owned some stock which was recalled by the company. I got the money, but I can’t remember what the tax implications were.

As you can tell, I’m a real wall street high roller. :slight_smile:

15

That’s an interesting question - how do you make your covering purchase (or do you even have to) if the company is no longer in business?

I don’t know the answer, but I’m willing to take a few guesses:

First, as a practical matter, this might not come up very often, because I have heard short selling is not allowed once a stock drops below $5/share. So the short positions may be mostly closed by the time of the bankruptcy filing.

Second, stock in a bankrupt company may resume trading at some point after the bankruptcy filing. Why would anyone pay 5 cents a share for a company that’s in chapter 11? I have no idea, but perhaps the shares give you some kind of voice in the bankruptcy proceeding a chance to receive some scrap of something? Or maybe 5 cents is what short sellers are paying just so they can close their positions?

These are just WAGs. I’m totally speculating here.
If any wall-street types out there know the answer, I’d be interested to know.

16

Bankruptcy does not stop trading in the stock. It can remain listed and traded. Even if there’s a serious problem and the company is delisted, you can still buy shares of it – it’s just harder to find.

Of course, bankruptcy can kill the price of the stock; and if it’s truly going belly up, it’ll only sell for a few dollars.

That would be a short seller’s dream – to short it when the stock is as 50 and buy back the shares at 5.

17

Just some general agreement with several of the comments here.

One example of using short selling as a hedge is in the case of my own company, which has an employee stock purchase plan. The cash is set aside for purchase during the course of the year, but the purchase price is set at year end. In a recent year, the price had risen 50% at one point during the year, and I, afraid that it would drift on back down, shorted the amount I was to purchase at the then current amount, thus locking in the current price. (This is similar to the situation described by Autumn Wind Chick). Such a situation could also be dealt with by use of a put option.

All things being equal, a stock that has a large short interest is a better buy than a stock that does not. This is because the downward pressure caused by all the short sales is already factored into the current price. Meanwhile, all these shorts will eventually have to cover, which will, sooner or later, exert some upward pressure on the stock price. (Of course, the stock may go bankrupt, but if it does, short positions are the least of your worries).

However, it is widely thought that short sellers are frequently on to something. This is possibly due the fact that short sellers face unlimited liability and are furthermore bucking the trend (most stocks rise over the long term). This tends to suggest that short sellers may tend to have carefully thought out reasons for shorting before undertaking such a risky proposition (as opposed to longs, who may be along for the ride). In any event, many people are wary of purchasing a stock with a large short interest, for fear of having the shorts turn out to be right.

Someone stated earlier that a stock valued at less than $5 cannot be shorted. This is not correct. (It is true that such stocks cannot be bought on margin).

It has recently been suggested, by executives of a stock that had a large short interest, that the longs can deliberately set out to squeeze the shorts. This was to be accomplished by putting in GTC (good till cancel) orders en masse to sell the stock at some very high price (say, 5 times the current price). It was suggested that brokers would be unable to leave these shares borrowed due to the outstanding orders, and would force widespread short covering. I’m uncertain if this strategy was (or could be) succesful.

18

Change the second sentence of the second paragraph to read

19

Yep, a buy-write or covered call strategy. You own stock and think the price will be flat to negative over the next year, but you want to keep this core holding. You could sell a call option on your stock and pocket the premium. If the price goes up beyond the premium amount, then you’ll be in trouble. Actually, in this example you would be long stock and short a call, which means you have a synthetic short put position.

There’s all sorts of financial engineering you can do with options and shorting stock or shorting options and going long stock.

Okay, maybe for most individuals it makes sense to just sell you stock rather than short as a hedge. For trust funds, fund management companies, etc maybe you can’t sell your position, but you think it’s going down, so you hedge by shorting the stock.

Now, having helped blow up Thailand, Malaysia, Indonesia and Korea, I will have to say that most people short as a means to get rich quick rather than as a hedge.

20

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It’s a Stock Market game we’ve been playing for a while amongst the Dopers. We’re up to Round IV now… click the link in my sig: