 Personal Finance PowerPoint Presentation, Short Selling. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Short Selling, which you can find online. Take a look at the references, resources, continue your research from there. This by Adam Hayes, updated March 1st, 2022. In prior presentations, we've been taking a look at investment goals, strategies, tools, keeping in mind the two major categories of investments, that being the fixed income, typically the bonds, the equities, typically the common stock. Also keep in mind the tools that you are using, which could include things like mutual funds, ETFs, helping you to pool resources together, possibly leading you to make different investment decisions to diversify than if you're buying individual stocks, in which case, you might be drilling down onto the financial statements for those particular companies doing ratio analysis and trend analysis on them. Keeping that in mind, what is short selling? Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. So typically when we're investing, the strategy is to buy low, sell high. So usually we're gonna be purchasing when we think that there's gonna be an increase in the price and selling when the price is high would be the general idea. Here we're basically betting that there's gonna be a decline in the price. So the idea would be, if I think that there's gonna be a decline in the price of stock, is there a trading strategy that I could use to benefit on that prediction? If I'm doing it for speculative purposes, the short sell might be the tool there. It is an advanced strategy that should only be undertaken by experienced traders and investors. So long-term investors trading for something or investing for something like retirement, probably will not be looking at this strategy. They might be using tools such as mutual funds, ETFs under umbrellas like IRAs and tax benefit type of funding like IRAs and 401K plans and probably aren't looking at those short sales, which are typically more experienced traders looking at that might be looking at that for speculative purposes, possibly looking to make a profit basically on the short term, as opposed to someone saving for retirement, which is putting money away and generally playing the long-term game and looking to diversify on it. So traders may use short selling as a speculation and investors or portfolio managers may use it as a hedge against downside risk of a long position in the same security or a related one. So pure speculation would be, I think this is gonna happen in the future with this particular stock and I would like to put in a strategy to profit from my guess in the short term. A more of a hedge would be a more kind of of a sophisticated plan within your portfolio that you're using it in a specific way to lower the risk of the portfolio. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure. In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. So we're gonna be borrowing the shares, we think they're gonna be going down in value in the future. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline. So by the time they actually have to be giving the borrowed shares, they're expecting the price to go down in that timeframe so they can purchase them at a lower cost. If that was to happen, in other words, you can complete the promise at the lower price because you're gonna be buying them in the future and you're expecting the cost to go down. The risk of loss in a short sale is theoretically unlimited since the price of any asset can climb to infinity. So in other words, the thing that you can get caught up easily in a short sale and can be very painful is that you promise to give these shares that you're gonna be purchasing in the future expecting the price to go down, but the price skyrockets, right? And now you've got it, now you've got to complete the promise, but you'll have to buy the shares at the higher price, which would not be good. So understand in short selling, with short selling, a seller opens a short position by borrowing shares usually from a broker dealer hoping to buy them back for a profit if the price declines. Shares must be borrowed because you cannot sell shares that do not exist. So to close a short position, a trader buys the shares back on the market hopefully at a price less than what they borrowed the assets and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades. So you're borrowing in essence here, so you could have some other added costs related to the borrowing of the funds that being interest, the rent on the purchasing power. So to open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also financial industry regulatory authority incorporated the FINRA, which enforces rules and regulations governing registered brokers and broker dealers firms in the United States, the New York Stock Exchange, NYSE and the Federal Reserve have set minimum value for amount that the margin account must maintain known as maintenance margin. So they're trying to regulate, how much you're gonna have to have in that account. So if an investor's account value falls below the maintenance margin, more funds are required or the position might be sold by the broker. The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platform with most brokers. However, each broker will have qualifications. The trading account must meet before they allow margin trading. Why sell short? Why do it? The most common reason for engaging in short selling are speculation and hedging. So speculation, you're just guessing in the future. You think things are gonna go down. You think you can predict the future and you're trying to play the speculation game on it to make some money on it. Hedging would be a situation where you're trying to strategically use this method to adjust for undue risk in your portfolio. So a speculator is making a pure price bet that it will decline in the future. If they are wrong, they will have to buy the shares back higher at a loss because of the additional risk in short selling due to the use of margin. It is usually conducted over a smaller time horizon and is thus more likely to be an activity conducted for speculation. So when you're doing speculation, you're often looking at the shorter term. Remember when you're thinking about your investing strategies, you gotta think of my looking at long-terms horizons, medium-terms or short-terms because the activity of the market will of course be different in concept between those different time horizons you're gonna be focused in on. People may also sell short in order to hedge a long position. For instance, if you own a call options which are long positions, you may want to sell short against that position to lock in profits. Or if you want to limit downside losses without actually exiting a long stock position and can short in a stock that is closely related or highly correlated with it. Example of short selling for a profit. Imagine a trader who believes that XYZ stock currently trading at $50 will decline in price in the next three quarters. So we know it's not inside information but I have some special information. I know the stock's gonna go down or something like that. I know some Congress people passing some laws. No, we just know we've got some speculation. Crystal Ball says so they borrow 100 shares and sell them to another investor. So they borrow the shares, they sell the shares to another investor. The trader is now short 100 shares since they sold something that they did not own but had borrowed. So now we've sold something that we don't actually have. So the short sale was only made possible by borrowing the shares which may not always be available if the stock is already heavily shorted by other traders. A week later the company whose shares were shorted reports a dismal financial results for the quarter. I told you my resources are always correct but actually it was just my crystal ball. No one told me anything but. And stock falls $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader's profit on the short sale excluding commissions and interest on the margin account is $1,000, $50 minus $40 equals $10 times the 100 shares or $1,000. Example of short selling for a loss using the scenario above. Let's now suppose the trader did not close out the short position at 40 but decided to leave it open to capitalize on further price decline. So now they're getting greedy. They're saying, I knew it, it was gonna go down but I'm holding out here. However, a competitor swoops in to acquire the company with a takeover of a $65 per share and the stock soars. So if the trader decides to close the short position at 65, so now it went up in price, that's not good. The loss on the short sale would be $1,500. That's the $50 minus the 65, negative $15 times 100 shares. That's how we get the 1,500. Here, the trader have to buy back the shares at a significantly higher price to cover the position. Example of short selling as a hedge then. Apart from speculation, short selling has another useful person, hedging after perceived as the lower risk and more respectable avatar of shorting. So hedging would be more of a general business use that would make sense as opposed to speculation which is kind of gambling or kind of projecting into the future. So the primary objective of hedging is protection as opposed to the pure profit motivation of speculation. Hedging is an undertaking to protect gains or mitigate losses in a portfolio but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times. The cost of hedging are two-fold. There's the actual cost of putting on the hedge such as the expenses associated with short sales or the premiums paid for protective options contracts. Also, there's the opportunity cost of capping the portfolios upside if markets continue to move higher. So in other words, you know, there's risk and rewards being in play here. So if the markets continue to go up, you're gonna have some more upside if you don't hedge but the hedging will basically save you in the event that the market shifts in the way it's basically going. So you've got the cost of the opportunity cost because you're gonna have less upside but you're gonna hopefully mitigate the downside and you've got the cost of implementing the tool that you're gonna use for the hedging. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 is hedged and the index moves 15% over the next 12 months, the portfolio would only record approximately half of that gain or 7.5%. Pros and cons of short selling, the selling short can be costly if the seller guesses wrong about the price movement. So obviously if you're wrong on the short sale, that's not good. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero. However, a trader who has shorted stock can lose much more than 100% of their original investment and that's because if you buy the stock, you know how much you put in. You're just gonna lose how much you put in if the stock goes down to zero. If you short, you don't know what the price of the stock could be. If so, the stock just went up by crazy. If there was a hostile takeover that was good or something for the stock and it went up, then that could be costly. And you don't know how costly it is whereas if you just bought the stock, you know how much that you have to lose. The risk comes because there is no ceiling for the stock's price. It can raise to infinity and beyond to coin a phrase from another comic character Buzz Lightyear. Also, while the stocks were held, the trader had to fund the margin account. So even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits. So the pros, a possibility of high returns, little initial capital required. So that's another big pro that some people might look as advantageous. You don't really need the cat. You know, you could borrow the funds to initiate the short leverage investments possible. So hedge against other holdings. Cons, potentially unlimited losses, margin account necessary. So you need a more complex kind of setup. Margin interest incurred. So you got interest that you got to deal with. Short squeezes. So when it comes time to close the position, a short seller might have trouble finding enough shares to buy if a lot of other traders are also shorting the stock or if the stock is thinly traded. Conversely, sellers can get caught in a short squeeze loop if the market or a particular stock starts to skyrocket. So on the other hand, strategies that offer high risk also offer high yield reward. Short selling is no exception. If the seller predicts the price moves correctly, they can make a tidy return on investment, ROI, primarily if they use margin to initiate the trade. Because they're basically using a leverage kind of component that we talked about in prior presentation when you kind of buy on margin. So using margin provides leverage, which means the trader did not need to put up much of their capital as initial investment. If done carefully, short selling can be an inexpensive way to hedge, providing counterbalance to other portfolio holdings. Beginning investors should generally avoid short selling until they get more trading experience under their belts. That being said, short selling through ETFs is a somewhat safer strategy due to the lower risk of a short squeeze. So you could ETFs are kind of similar to mutual funds, but they trade more similarly to stocks. So you could use similar strategies with individual stocks on the ETFs, which are kind of similar to mutual funds and that they are a grouping of portfolio, for example. And they're usually based on indexes that we've talked about in prior presentations. Additional considerations with short selling. Besides the previously mentioned risk of losing money on a trade from a stock's price rising, short selling has additional risks that investors should consider. So we got the shorting using borrowed money. Shorting is known as margin trading. When short selling, you open a margin account which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to margin call and forced to put in more cash or liquidate your position. Wrong timing. Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest margin calls and being called away. So in other words, even if you've predicted, you say, hey, I know that the stock is overvalued. I think it's gonna have to go down in price in the future. You don't know exactly when the market might react, even if you made the right call that it was overvalued. So the short squeeze, if a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, the short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. So now you have a situation that people have shorted the stock, right? But the stock now is going up and people are trying to get out while the stock is going up. And that actually creates this feedback loop of the stock going up. And you can get stuck in that feedback loop. So demand for shares attracts more buyers which pushes the stock higher, causing even more short sellers to buy back or cover their position. Regulatory risks. Regulators may sometimes impose bans on short sales in a specific sector or even in the broad market to avoid panic and unward to selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses, going against the trend. History has shown that in general, stocks have an upward drift. So over the long run, most stocks appreciate in price. So we would hope that the companies are gonna basically generally go up. There's gonna be, you know, as we've seen a bunch of times, but if we zoom in, there's gonna be peaks and troughs, but we would hope that most stocks are gonna have a longer term trend that's basically an upward types of trend. That's why the short sales are typically something that happens on the shorter time frames if you're doing it for speculative purposes, which means you're looking for these short term peaks and troughs rather than what hopefully will happen most of the time in the long run, which is a long term growth trend. So for that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. So what this means is that shorting is betting against the overall direction of the market. So if the stock is generally gonna be going up, you're actually betting that it's gonna go down in the short run. So you're actually kind of betting against the upward trend because you're betting on the short term moves. So cost of short selling, unlike buying and holding stocks or investments, short selling involves significant costs in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include margin interest. Margin interest can be a significant expense when trading stocks on margin, so you're taking out a loan basically for the stocks, you gotta pay the interest on it. So since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period. You got the stock borrowing costs, shares that are difficult to borrow because of high short interest, a limited float or any other reasons have hard to borrow fees that can be quite substantial. The fee is based on the annualized rate that can range from a small fraction to a percent to more than 100% of the value of the short trade and is prorated for the number of days that the short trade is open. So as the hard to borrow rate can fluctuate substantially from day to day and even on an intraday basis, the exact dollar amount of the fee may be known at in advance. The fee is usually assessed by the broker dealer to the client account either at month end or upon closing of the short trade and if it is quite large can make a big dent in the profitability of a short trade or ex-surbate losses on it. So we got dividends and other payments. The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. So the dividends would typically be the money that's coming from the company from retained earnings to the owner of the shares. So the short seller is also on the hook for making payment on account of other events associated with the short stock, such as share splits. So if there's a split involved that'll complicate the situation, spin offs. So that'll complicate the situation and bonus share issues, all of which are unpredictable events. So if you're in the middle of a short sale and then they have a stock split, but now all of a sudden you've got to twice as many stocks that you're kind of on the hook for and so on, although you would expect that half the price but obviously that'll complicate things. So short selling metrics, two metrics used to trade short selling activity on a stock or we got number one, short interest ratio SIR also known as the short float measures the ratio of shares that are currently shorted compared to the number of shares available or floating in the market. A very high SIR is associated with stock that are falling or stocks that appear to be overvalued. So you can look at that as a kind of an indication. Number two, the short interest to volume ratio also known as the days to cover ratio, the total shares held short, divided by the average daily trading volume of the stock. A high value for the days to cover ratio is also a bearish indication for a stock. Both short selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock. For example, after oil prices declined in 2014 general electric GE energy divisions began to drag on the performance of the entire company. The short interest ratio jumped from less than 1% to more than 3.5% in the late 2015 as short sellers began anticipating a decline in the stock. By the middle of 2016 GE's share price had topped out at $33 per share and began to decline. By February 2019, GE had fallen to $10 per share which would have resulted in a profit of $23 per share to any short seller lucky enough to short the stock near the top in July 2016. Ideal conditions for short selling. Timing is crucial when it comes to short selling. Stocks typically decline much faster when they advance and a sizable gain, a sizable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. So clearly you got some key days that could, when their earnings come out and so on and so forth that would be the opportunity for that, the stocks to fall during a short time frame for example, the short seller thus has a time, has to time the short trade to near perfection. So again, this is why this is a more advanced technique if you're doing it purely for speculation because you're looking up fairly small time frames in that case. So entering the trade too late may result in a huge opportunity cost in terms of lost profits since a major part of the stock's decline may already have occurred. So on the other hand, entering the trade too early may make it difficult to hold onto the short position in light of the costs involved in potential losses which would skyrocket if the stock increases rapidly. There are times when the odds of successful shorting improve such as the following. During a bear market. So the dominant trend for stock market or sector is down during a bear market. So a bear market of course, meaning the market in general is going down. So clearly you would be more likely to bet in the right direction if you're betting on something going down, if you're in a situation or environment where everything is going down. So traders who believe that quote, the trend is your friend, end quote have a better chance of making profitable short sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers reveal an environments where the market decline is swift, broad and deep like the global bear market of 2008, 2009 because they stand to make winful profits during such times. When stock or market fundamentals are deteriorating. So a stock's fundamentals can deteriorate for any number of reasons, slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins and so on. So for the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like the threat of war, a bearish technical signals like reaching new highs and decreasing volume, deteriorating market breadth. So we've got the experienced short sellers may prefer to wait until the bearish trend is confirmed before putting on short trades rather than doing so in anticipation of a downward move. So they might actually look for the move to start down because then you would think that, you know, you're more likely to make a good guess because it's already on the down shift. This is because of the risk that a stock or market may trend higher for weeks or months in the face of a deteriorating fundamentals. So in other words, you're seeing the fundamentals go down but the market psychology is such that that might not actually draw down the stock price until some future point. So you might be fairly convinced the stock price is gonna go down some point but you don't know exactly when that's gonna happen. Once this trend down starts to happen, it often, you know, the sentiment in the market will build on itself and we think that it might keep going down to what you think the fundamentals should reflect. So it is typical of the case in the final stage of the bull market. Okay, so we got the technical indicators confirmed the bearish trend. So short sales may also have a higher profitability of success when the bearish trend is confirmed by multiple technical indicators. These indicators could include a breakdown below a key long-term support level or a bearish moving average crossover like the death cross. So an example of a bearish moving average crossover occurs when a stock's 50-day moving average falls below its 200-day moving average. A moving average is merely the average of a stock's price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price. Valuations reach elevated levels amid rampant optimism. Occasionally, valuations for certain sectors or market as a whole may reach highly elevated levels amid rampant optimism for long-term prospects of such sectors or the broad economy. So now you've got people's sentiments looking like they're outpacing what you would think the fundamentals would be. Market professionals call this phase of the investment cycle price for perfection since investors will inevitably be disappointed at some point when their lofty expectations are not met. So you would think that at some point they're gonna see that they're not looking at things properly. Rather than rushing in on the short side, experienced short sellers may wait until the market or sector rolls over and commences its downward phase for the same reason, because even if you think that's the case, you don't really know when the realization will happen although you think it will happen. So John Maynard Keynes was an influential British economist whereby his economic theories were still in use today. However, Keynes was quoted saying, quote, the market can stay irrational longer than you can stay solvent, end quote. So in other words, if you're playing the long game, the Keynes would basically say and the long we're on, we're all dead, right? So he would be saying you can't really depend on a long game too much. You could argue that back and forth, but the question is where, how sticky are the market prices gonna be even if you're making good predictions based on the fundamentals and how do you play those given market sentiments on different time frames like short term, medium term and long term perspectives? So which is particularly apt for the short selling. So the optimal time for short selling is when there is a confluence of the above factors. Short selling reputation, sometimes short selling is criticized and short sellers are viewed as ruthless operators out to destroy companies. So in other words, a lot of times, if you say I do a lot of short selling, people would say well that's not a very dignified profession or something like that because you're betting against the market and so on and this and that. However, the reality is that short selling provides liquidity meaning enough sellers and buyers to markets and can help prevent bad stocks from rising on hype and over optimism. So clearly short selling plays a role that's critical so there could be problems with the functionality of it but obviously if you truly think that a stock is overvalued and you could short sell it that's gonna help the market forces to drive the market price you would think to what would be a more optimal position. So evidence of this benefit can be seen in asset bubbles that disrupt the market assets that lead to bubbles such as the mortgage backed security market before the 2008 financial crisis are frequently difficult or nearly impossible to short. Short selling activity is a legitimate source of information about market sentiment and demand for a stock. So again, if someone really has the information you might say well they're just being greedy because they're short selling and obviously there's insider trading and this kind of stuff involved but if they're really looking at the fundamentals and they're able to say hey the stock is overvalued and they're shorting it and they're playing that role then that's valuable if they're correct about it because that's gonna drive the stock price again using the market forces to make us realize the reality of the situation based on the market. So without this information, investors may be caught off guard by negative fundamental trends or surprising news. Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short selling strategies and derivatives to artificially deflate prices and conduct bear raids on vulnerable stocks. So if you're using the short selling because you have the market power to actually drive the market down not based on fundamentals but based on your activity you're driving the market down then of course that would be kind of an abusive strategy that isn't getting more information to the market but rather is abusing the power that you have to influence within the market and that would be a negative kind of use of it. So most forms of market manipulation like this are illegal in the US but it still happens periodically. Real world example of short selling, unexpected news events can initiate short squeeze which may force short seller to buy at any price to cover their margin requirements. For example, in October 8th, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze. In 2008 investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company the stock would likely fall in value so they heavily shorted the stock. However, in a surprise announcement Porsche revealed that they had secretly acquired more than 70% of the company using derivatives which triggered a massive feedback loop of short sellers buying shares to close their position. Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn't interested in selling and Porsche was controlled another 70% so there was very few shares available on the market float to buy back. So now you got this limitation. Essentially, both the short interest and days to cover ratio had exploded higher overnight which caused the stock to jump from a low of 200s to over 1000 euro. A characteristic of a short squeeze is that they tend to fade quickly and within several months Volkswagen stock had declined back into its normal range. Why is it called selling short? A short position is one that bets against the market profiting when prices decline. To sell short is to take such a bet. This is opposite to a long position which involves buying an asset in hopes the price will rise. Why do short sellers have to borrow shares? You cannot sell something that doesn't exist since a company has a limited number of shares outstanding. A short seller must first locate some of those shares in order to sell them. The short seller therefore borrows those shares from an existing long and pays interest to the lender. This process is often facilitated behind the scenes by one's broker. If there are not many shares available shorting, i.e. hard to borrow, then the interest costs to sell short will be higher. Is short selling bad? Well, some people think it is unethical to bet against the market. Most economists and financial professionals agree that short sellers provide liquidity and price discovery to a market making it more efficient. Can I sell short in my brokerage account? Many brokers allow short selling in individual accounts but you must first apply for a margin account. What is a short squeeze? Because short sales are sold on margin, relatively small losses can lead to ever larger margin calls. If a margin call cannot be met, the short must buy back their shares at ever higher prices. This works to bid the price of the stock even higher.