How Short Sellers Profit From Price Plunges

Making a Profit on Falling Stock Prices

To some people unfamiliar with how stock markets operated, investing in stocks is nothing more than gambling. In a sense, that view has some truth in it but in reality for the vast majority of investors, the “bets” placed on individual stocks are educated bets. Picking stocks is not a matter of throwing darts at a board. It requires time and effort to learn which stocks are worthy of a bet.

To the uninitiated, the only bet available is that the selected stock will go up in price, yielding a profit when the stock is sold. As contrary as it may seem, there is another bet open to investors – that the stock price of the selected stock will go down, also yielding a profit. How can that be?

The process of betting stocks will drop in price is called short-selling.

Short Selling Explained

Once a likely target is identified, the short-seller borrows the number of shares he or she intends to short from a brokerage house. The brokerage house dips into the portfolios of customers or their own stock holdings to borrow the stocks. Market experts advise investors opposed to short-selling to mark their holdings as not available for shorting.

The short seller may borrow 100 shares of a $10 stock, sell them with the $1,000 in proceeds going into his or her account. What baffles investors who simply buy  stock and wait for it to go up in price is the short-sellers do not own the stock they are shorting. However, in time they will have to cover” their short position by buying the shares to repay what was borrowed.

The profit comes when the $10 stock falls. If the stock drops to $5 the short-seller buys the stock at the market price — $5.00 – and pockets the $500  as profit – the difference between the $1,000 held in his or her account and the cost of buying the stock to cover.

Market experts strongly advise most retail investors to stray away from shorting as the risk involved is virtually infinite.

Had the investor  bought 100 shares at $10 as a “long” position, the potential loss is limited to the initial $1,000 investment should the stock enter receivership or bankruptcy.

But what happens to the short-seller if the $10 stock begins to climb, reaching $15 or even $20? The short-seller will incur a potentially substantial loss when buying the stock at $15 or $20 to replace the borrowed stock. This is one of the inherent risks associated with short-selling.

First there is the risk of margin calls. Aussie investors need to open and fund a margin account with their brokerage platform. Brokerage houses have minimum equity requirements for margined stocks that vary by brokerage and the selected stock. If the value in your margin account drops below the required minimum, the brokerage will issue a margin call, requiring the investor to deposit sufficient cash to get the account value back above the minimum.

The greater risk is a share price that keeps rising. Although short-sellers are unlikely to wait forever, in theory their potential loss is limitless if the stock price keeps climbing higher.

The Short Squeeze: When Short-Selling Goes Wrong

When a heavily shorted stock starts to rise, short-sellers can get “squeezed” to jump in and stop the bleeding. In the event the shorted stock is benefiting from a catalytic event, the shorts may stampede to cut their losses, driving up the price of the shares even further due to the increase in buying pressure.

The most recent example of a short-squeeze came when a band of young investors used a  massive social media campaign to what critics claimed was a manufactured short squeeze. The stock in question was GameStop, heavily shorted by both sophisticated retail investors and hedge funds and other institutional investors.

It was a perfect squeeze, as the demand from the social media campaign begin to drive short sellers to buy to cover their positions, driving the price up in a self-repeating cycle.

The short squeeze provides a major opportunity for sophisticated bargain hunting investors who make it a regular practice to follow the Top Ten ASX shorted stock lists. These lists rank ASX stocks by their percentage of shares shorted. Good news coming from one of the highly ranked shorted stocks is likely to yield some upward movement, if not an outright squeeze. Long time Aussie investors have seen  JB HiFi (ASX: JBH) hit the Top Ten short list again and again, beating the shorts every time, providing buying opportunities for investors following the stock.

Is it Short-Selling Legal? Is it Ethical?

Short-sellers have earned the accolades for being “the smartest guys in the room” because of their dogged search for underlying weaknesses in high flying stocks and in reality any stock that appears overvalued.

At best, some market experts view short-selling as unethical. At worst, some view short-selling as illegal. The GameStop fiasco reignited the regulatory debate in the US, but regulations against short-selling are not new.

At the core of the ethical debate lies the issue of deliberate market manipulation. While some short-sellers appear to spread questionable negative information to drive down the price of a shorted stock, there are others that in reality do markets a service by uncovering negative information about a stock the company is deliberately concealing from the light of day.

In the US, the scandal that engulfed energy company Enron was missed, with warning signs largely ignored by the majority of the US financial establishment, but not by the short sellers. It was short-sellers who broke that scandal wide open.

Deliberate market manipulation is not the exclusive province of short-sellers. From time to time articles have appeared in the US financial press reporting on a common manipulative practice – spreading rumors about a stock prior to market opening. Rumors are reported in the morning market coverage, driving down the stock price until later in the day when the market learns the rumors have no basis in fact. In the interim, manipulators have bought the stock as its price fell only to sell it for what often is a handsome profit late in the day.

The legal versus ethical question is a grey area.. In  the opinion of some market experts short-sellers uncovering negative facts should be applauded not attacked.

In contrast from profiting from taking a “long” position on a stock where an investor buys a stock and waits for the price to go up to take a profit, short-selling takes a diametrically opposed position. Shorts bet on stocks to fall in price. The process involves borrowing shares and selling them, depositing the proceeds in a margin account at a brokerage house. Overtime when the price falls below the shorted price, the investor steps in and buys the number of shares shorted, pocketing  the difference between the selling price and the buy-back price as pure profit.