Short Selling

Short selling is the mirror image of buying on margin. When you buy on margin, you buy stock that you can't afford. So you make some sort of down payment, then borrow the cash that you need to make the purchase. When you sell short, you sell a stock that you don't own. So you borrow the stock, pledging cash or some other asset as collateral for the loan. Then you sell the stock, in the hope that you will be able to buy the stock back in the open market at a lower price, at which point you can return the borrowed stock to the lender. The long investor hopes to buy low and then sell high; the short seller hopes to sell high and then buy low.

(If your eyes are starting to glaze over, don't worry. Short selling does that to people. Just relax. It will all be over in a few paragraphs.)

Short selling breaks down into three steps: You borrow the stock, you sell it short, and then you cover the short. Suppose that, during the height of the Internet bubble in late 1999, you begin to feel that Amazon.com is overvalued. You short Amazon at $100; then you cover your short at $50 in the middle of 2000. You've made $50 per share without ever owning the stock. How did this happen?

First you deposit money (or securities) into a margin account. Then you use that money as collateral to borrow the Amazon shares. This requires that somebody who owns Amazon be willing to lend you his shares. This is usually not a problem since anybody who owns stock in a margin account has consented to having his stock lent to other investors. The prime broker arranges the borrowing. This means, incidentally, that when a hedge fund manager chooses a prime broker, he will want, among other things, a broker who has excellent access to stock available for borrowing.

Then you sell the borrowed shares, and that sale produces real money, which is called the proceeds of the short sale. The proceeds of the short sale go into an account at the prime broker, where they earn interest. The interest is split three ways: the lender of the Amazon shares earns a lending fee, the broker earns a fee for arranging the transaction, and the short seller earns the remainder of the interest.

Let's assume that you open the account with $100,000, and you sell short 1000 shares of Amazon.com at $100 each. Then the assets and liabilities in the account are as shown in Table 9-2. The account has total assets of $200,000 and a liability that is originally valued at $100,000. So the net equity in the account is exactly $100,000, which was the starting amount. We added a new liability, and a new asset, but the net equity did not change.

When you buy on margin, the asset value fluctuates while the liability value remains stable. The object of the game is to increase the net equity by increasing the value of the asset. When you sell short, the asset value remains stable while the liability fluctuates. The object of the game is to increase the net equity by decreasing the value of the liability.

Both the margin buyer and the short seller have borrowed something that they must return. The margin buyer has to pay back a definite number of dollars, even if the asset that he bought becomes worthless. Similarly, the short seller has to return a definite number of shares of stock, even if those shares at the time have an astronomically high value.

Let's suppose that Amazon.com goes from $100 to $50, so the value of the liability goes from $100,000 to $50,000. This $50,000 decline in the value of the liability boosts the net equity in the account by $50,000. Now you can cover the short by taking $50,000 from the original deposit, buying Amazon in the open market, and then using

TABLE 9-2

Structure of a Short Position

TABLE 9-2

Structure of a Short Position

Assets

Liabilities

Original deposit $100,000 Proceeds of short sale $100,000

1,000 shares of Amazon.com $100,000

Net equity $100,000

the newly purchased shares to pay back the original borrowing of stock. At the end of the day there is $150,000 in the account, and no liabilities. You sold high and bought low. Or, more accurately, you shorted high and covered low.

The function of the original $100,000 deposit is to serve as collateral for the borrowing of the stock. If Amazon goes from $100 to $120, then the value of the liability goes to $120,000, the assets are still at $200,000, so the net equity is only $80,000. As the price of the shorted stock goes up, the broker begins to worry about getting paid back, and at some point he will make a margin call. At that time you can put more money into the account. If you do not, the broker will force you to cover the short at current prices. Like the leveraged long investor, the short seller may be forced to transact.

Notice that short selling creates a new interest-bearing asset. If you open the account with $100,000, and then short stock worth $100,000, there would then be $200,000 in the account that is earning interest. So even if the shorted stock appreciates modestly, you can make money if the appreciation in the stock does not cancel out the interest on double the account equity.

Short selling was an extraordinarily profitable strategy during the 1970s, when short-term interest rates were high and stock prices were weak. Suppose that short-term interest rates are at 10 percent, and you short a stock that goes down 5 percent. You earn 10 percent interest on the original deposit, 10 percent interest on the cash proceeds of the short sale, and a 5 percent gain on the short sale. Total return is 25 percent. Not bad, considering that the stock went down only 5 percent.

When you short a stock, you have to make sure that the lender of the stock continues to get any dividends to which she is entitled. So you have to make those up out of your own pocket. The borrowing fee that you pay is on top of any other income that the lender would ordinarily receive. This fact, by the way, sheds light on more familiar forms of borrowing. When you take out a home mortgage at 8 percent, you may think that you are paying an 8 percent borrowing fee. That is not exactly right. The person who lends you the money could invest that money in bonds to earn, let's say, 6 percent. When you pay 8 percent, you are paying out 6 percent to make sure that the lender gets what she would have earned otherwise, and then you are paying a borrowing fee of 2 percent or so. This phenomenon applies also to U.S. Treasury bills, which are often regarded as risk-

free investments. Those who invest in Treasury bills earn "the risk-free rate." But nobody can borrow at the risk-free rate. If you borrow Treasury bills, you owe the lender the risk-free rate and then you owe a borrowing charge.

Borrowing rates are set by supply and demand. If a stock is hard to borrow, then the lender of the stock will demand a higher interest rate, so the short seller will earn a correspondingly lower rate on the proceeds of the short sale. It is also worth noting that when small retail investors engage in short selling, they often receive no interest at all on the proceeds of the short sale. What would have gone to the short seller is simply retained by the broker who arranges the stock borrowing.

There are two aspects of short selling that make it more troublesome than long investing. First, the short seller has limited upside potential but unlimited downside risk. This is opposite to long investing, in which the investor faces limited downside risk and unlimited upside potential. If you buy a stock at $100 per share, the worst that can happen is that it goes to zero. But it could go to $500, or $1000. If you short a stock at $100, the best that can happen is that it goes to zero. But there is no worst case: The stock could go to $500, or $1000, or higher. Of course, the short seller may decide to cover the short before this happens, or he may be forced to cover by a margin call. But if the short seller is willing to put additional equity into the account, then the losses can go up without limit. This is the nightmare scenario of the runaway short. So the short seller needs to be even more vigilant about cutting losses than the leveraged long investor.

The second troublesome feature of short selling is that losing positions become a bigger piece of the portfolio, so the total portfolio becomes increasingly sensitive to your mistakes. To see this, consider an unleveraged $1,000,000 portfolio that consists of nine long positions, at $100,000 each, and one short position, initially valued at $100,000. Now suppose that one of the long positions goes down by 50 percent, while everything else remains the same. The losing position is now worth $50,000, while the total portfolio is worth $950,000. So the losing position, which started out at as a 10 percent position, becomes a 5.3 percent position. The total portfolio is then less responsive to further declines in the price of your mistake.

But now suppose that the short position goes from $100,000 to $150,000, while everything else remains the same. Then the total portfolio is again worth $950,000 (the appreciation in the short position counts as a loss), while the losing position is $150,000, or 15.8 percent of the total. What began as a 10 percent position is now a 15.8 percent position. So the total p ortfolio is now more responsive to further appreciation in the stock you were wrong about.

In a well-diversified long portfolio, you can afford to make a few mistakes. The mistakes get smaller and smaller until you can almost forget about them. In a well-diversified short portfolio, your mistakes get bigger and bigger, and eventually they can put you out of business.

The short seller operates from a doubly vulnerable position. He accepts unlimited downside in the pursuit of limited upside and pursues a strategy in which mistakes become more and more visible. Experienced hedge fund managers treat their short positions with a vigilance that borders on paranoia. In particular, diversification is even more important on the short side of the portfolio than on the long side. Many managers have position limits designed to enforce a certain degree of diversification on the long side. For example, a manager might have a rule that he will not place more than 5 percent of the portfolio in a sin gle long position. If the upper limit on the long side is 5 percent, then the upper limit on the short side may well be 2 or 3 percent, in order to allow for the fact that short positions become bigger when they move against you.

Short selling involves borr owing, which creates the risk of the margin call. Just as the leveraged long investor may be forced to sell in a falling market, so the short seller may be forced to buy in a rising market. This forced buying can lead to a short squeeze, in which short sellers are forced to cover their positions at disadvantageous prices. In addition, a short squeeze can result if the owners of a stock decide to make their stock unavailable for borrowing. When the short seller borrows stock, the l oan is a demand loan. If the lender wants the stock back, the borro wer must either borrow stock from somebody else or buy the stock in the open market.

Some investors feel that a large short position in a stock can be a bullish sign. The reasoning here is that if the stock does start to move up, then short sellers will exper ience margin calls, and hence there will be forced buying in the stoc k. The forced buying will accentuate the upward move already in pla ce. All this is certainly true. But bear in mind that the upward move may never develop, in which case the shorts will make money and esc ape the pain of forced covering.

The analogy between shorting and leverage is helpful here. If a large short interest can be a bullish sign, then a large leveraged long position can be a bearish sign. If a stock is owned mainly by investors who have borrowed money to buy the stock, then any meaningful decline in the stock will trigger margin calls, which will trigger further declines. But if the stock keeps moving up, then the leveraged long investor will make money and escape the pain of forced selling.

The stock exchanges have imposed various rules to limit the activities of short sellers. For example, there is the uptick rule, which means that a stock can't be sold short when the price is going down. This rule is designed to prevent bear raids in which short sellers gang up on a stock already in free fall, thus exacerbating an already difficult situation. Notice that there is no analogous rule on the long side. If prices are going up, investors are welcome to buy, even if they are buying on margin. This is one of the ways in which the stock market favors the longs over the shorts. The futures markets offer a more level playing field, as we shall see in Chapter 10.

Short selling is a relatively minor activity when compared to the total size of the U.S. equity market. For example, at the end of 2001 the New York Stock Exchange reported that there were approximately 6.5 billion shares sold short. Remember, the obligation of the short seller is to return a fixed number of shares no matter what their price is. So short interest is always reported in shares, not dollars. If we assume an average share price of $50, this works out to $325 billion in short positions. This sounds like a lot of money, but it's smaller than the market cap of General Electric (roughly $400 billion) and represents only about 3 percent of the market cap of the S&P 500.

When short sellers put on their positions, they are usually very careful to size their positions in such a way as to avoid liquidity problems. They want to be sure that they can cover their short in the event that the stock rises sharply, so they want their position to be manageable relative to the size of the company, and relative to the trading volume in the stock. The short interest ratio (sometimes called days to cover) is an important statistic for the short seller. Suppose that XYZ is a small company for which the average daily trading volume is only 20,000 shares. And suppose that the total short interest is 1 million shares: Short sellers, in aggregate, are short 1 million shares of the company. This short interest represents 50 days of average trading volume, which means that covering the shorts would be a long and tricky proposition. In a situation like this, the potential for a short squeeze is high, so hedge fund managers are wary of stocks that already have a large short interest.

Despite all the perils mentioned above, short selling can be an extremely useful strategy when intelligently applied within a broader portfolio context. As we have noted before, the ability to take short positions makes it easier to build well-diversified portfolios. In addition, most investors focus their research efforts and their analytical capabilities on identifying stocks to buy. In particular, most of the research generated by the large Wall Street brokerage houses focuses on buy recommendations, not sell recommendations. So the short seller is following the time-honored strategy of devoting her efforts to an area that most people are not covering. This has the opportunity to create incremental return.

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