Shorting a stock is often perceived to be the work of Wall Street villains, out to destroy companies at a whim.
Australia's most shorted stocks
According to ASIC data at the beginning of December, Australia's most shorted stocks were Myer Holdings Ltd (ASX: MYR), Western Areas Ltd (ASX: WSA), Aconex Ltd (ASX: ACX), Nine Entertainment Co Holdings Ltd (ASX: NEC) and Metcash Limited (ASX: MTS).
What is stock shorting?
Some people take up arms against short selling because it helps investors, usually fund managers, make a profit when a stock falls. By nature, 'shorters' hold a negative view of a stock, which is in stark contrast to ordinary investments which by their very nature require optimism. Company management in particular do not like shorters, for obvious reasons.
How it works
A short position starts like any other investment. Rigorous due diligence uncovers a valuation mispricing or catalyst to trigger a change in stock price. For example, analysts may believe Myer will fail to grow revenues the in near future and the share price will fall. Hence, they may look to take a short position.
The next step is to find another investor who owns the stock. These shareholders are typically investment banks (e.g. Goldman Sachs, Deutsche Bank, etc.), large superannuation funds, or index funds e.g. Vanguard, iShares, StateStreet. These massive asset managers may be required to hold a stock (e.g. Myer) because it is included in an index, such as the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO). Unless the stock is expected to be dropped from the index, these 'institutions' could consider lending the stock to the fund manager.
The fund manager will 'borrow' the stock from the institution with a guarantee to return it sometime in the future. It can be thought of as a loan which requires the fund manager to not only pay back the 'principal' by returning the stock but also pay an 'interest' rate. Typically, interest rates vary between 3% p.a. and 10% p.a.
Having acquired the stock from the institution, the fund manager will sell it on the market. For example, the fund manager may sell 1,000,000 Myer shares at today's price of around $1.25, yielding them $1.25 million. They may decide to invest this money in another stock or keep it in cash. The more aggressive fund managers will find another stock to buy with the proceeds rather than move it to cash.
Now imagine that in three months we find out Myer suffered some type of computer glitch during the busy Christmas period and is forced to report a profit downgrade to the market. Shares are likely to fall — but nothing is guaranteed.
Let's imagine shares fall to $1 each.
Our fund manager, knowing he still owes the institution its 1,000,000 Myer shares, decides to close out the deal. He buys 1,000,000 shares in the market for $1 each (costing $1 million) and returns the stock to the institution who also charges 1% interest for the deal (remember, it was only three months).
In summary, we have $1.25 million minus $1 million minus $12,500 (interest) = $237,500. That is a 19% profit to the fund manager in just three months!
Remember, however, that figure doesn't include what he did with the $1 million proceeds, i.e. he may have earned interest, or bought another stock with dividends, etc.
It can go wrong, very wrong!
The example I just gave you would be a successful short trade. But make no mistake they often go wrong — sometimes very wrong. In our example, imagine if the share price jumped 50 cents! Our fund manager would be hugely out of pocket.
Ultimately, short sellers take a huge risk for a huge profit.
For example, in a normal stock investment like you and I would enter, the maximum loss is 100% of our investment — but the upside is unlimited. For our shorter, the maximum upside is 100% – but the downside is unlimited!
Successful shorting requires both timing and a catalyst. Further, the ideal targets for short sellers are companies which operate in a structurally challenged industry (e.g. print media) and have a sub-par service or product.
Shorters must also be mindful of a short 'squeeze', which occurs when a number of shorters rush into the market to close out their position, but there is insufficient liquidity in the form of sell orders. When these big short sellers rush the market a stock's price jumps higher, and higher, until they acquire the full order. This can ruin their trade.
Regulatory handbrakes
During the Global Financial Crisis of 2008, the Australian Securities and Investment Commission banned short selling because it believed it exacerbated stock price volatility, particularly in financials. To this day, 'naked' short selling (selling a stock without owning it) is prohibited.
Short Sellers: Good, Bad or Evil?
We have already acknowledged the risk short sellers take in making their ends meet. Proponents of shorting argue many number of things. For example, they believe that it enhances the pricing efficiency of a market and improves liquidity. Those against short selling will say that it takes advantage of companies when they are most vulnerable.
I can think of a lot of other professions which do the same thing!
