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Short-selling explained

Photo of Michael Kemp, author Uncommon Sense By Michael Kemp, author Uncommon Sense

min read

The features, benefits and risks of using short-selling to profit from a negative view.

The 45-year-old billionaire pulled his mobile phone out of his pocket and proceeded to post a tweet that was targeted at trading rooms around the world.

Some traders who read it grinned wryly, not unlike the grin that was on the billionaire’s face when he sent it. Other traders squirmed uncomfortably. For them it was an unwelcome reminder that they were currently haemorrhaging money.

The billionaire was the world-famous Elon Musk, both creator of the revolutionary electric Tesla motorcar and head of SpaceX, the company that is rewriting the rulebook on how we explore the realms of outer space.

The four-word message Musk tweeted was simply: “Stormy Weather in Shortville”. This article explores why such a simple message carried so much impact.

What short-selling is

Musk’s reference to Shortville was his humorous twist on an activity that’s been going on in financial markets for a long time. It’s called short-selling or going short or simply shorting.

To successfully explain what short-selling is, I need you to read the following words very carefully, because the first time someone tried to explain it to me (in a trading room in Sydney more than 30 years ago) my head started to hurt.
Short-selling means selling something you don’t own. In terms of financial markets that could be pretty much anything – shares, currencies, oil futures, bonds and so the list goes on and on. The principles underlying the activity of short-selling are much the same for any commodity or financial instrument you wish to name.

But I’m going to limit discussion in this article to the short-selling of shares.

So why would you, and come to think of it how could you, sell shares you don’t even own?

Why sell something you don’t own?

Traders short sell because they believe that a company’s share price is heading south. They sell it now at a high price with the aim of buying it later at a lower price, so pocketing the difference between the two prices. It’s pretty much the opposite of how investors usually go about things – that is, buying at a low price and hoping to sell later at a higher price.

And this explains why Elon Musk was grinning as he posted his tweet. The traders in Shortville had sold short Tesla shares. Musk knew that all who short a stock (sell) must eventually buy an equal number of shares to close out their short position (you can’t simply sell and then do nothing).

And since Tesla’s share price was rocketing (sorry about that) the traders who were short Tesla were staring down the barrel of huge potential losses.

And how can you sell something you don’t own?

There are basically two types of short-selling. They are referred to as covered short sales and naked short sales. A naked short sale refers to selling shares when there is no offsetting form of ownership of those shares. And that’s illegal.

But the Corporations Act does allow covered short sales. This is where, prior to the sell order being executed, a share lending arrangement is entered into. That arrangement is established between the person or entity planning to undertake the short sale and a third party (who does at present own the shares). The Act describes this as a “presently exercisable and unconditional right to vest the securities in the buyer”.

Basically, what it means is the short-seller pays a third party (who owns the shares) to enter into an agreement with them so they can borrow the third party’s shares for a while. Then the short sale is OK. Hence the term covered.

What will they think of next?

If you think this all sounds like another New Age, wizbang, 21st century, digitally driven creation of some Y-Gen financial quant nerd, you would be wrong. Short-selling shares has been with us for centuries – four centuries, in fact.

The first time that shares were freely traded between stock-punters (like shares are today) was in 1602 when shares in The Dutch East India Company were created. It was only six years later, in 1608, that Antwerp merchant Isaac Le Maire organised a syndicate to short sell Dutch East India stock.

Le Maire probably did not realise it at the time, but he kicked off a craze that became a really big thing. Short-selling has been a favourite sport of traders (and hedgers, but that’s another story) ever since.

Has short-selling been given a bum wrap?

Over the past 400 years, short-sellers have copped more abuse than an umpire at a Carlton v. Collingwood AFL match. The simple fact is, there are lots of people who believe short-selling is the scourge of the financial markets.

There’s nothing new about this view but, by way of example, consider the recent comments from Gerry Harvey, the chairman of Harvey Norman. Following a 15 per cent plunge in Harvey Norman’s share price in mid-March, he publicly criticised short-sellers, claiming they were partly responsible for the price plunge.

The reality is that short-sellers are always active but most of the time people do not really care about what they are up to. But attitudes towards short-selling can change very quickly, especially when people start losing money. Broad-based investor sentiment can also turn against short-sellers when the whole sharemarket is in meltdown, as happened in 1987 and 2008/2009.

If you look back in history, short-selling has been implicated, to some degree or other, in just about every past market crash you can name. The first legislation banning it was by the Dutch authorities in the wake of Isaac Le Maire’s 1608 raid.

Flicking further through the annals of history (or alternatively through my book, UnCommon Sense – Investment Wisdom since the Stock Market’s Dawn) we find that the English government also banned it the year after the infamous South Sea Bubble of 1720. It legislated “an Act to restore Publik Credit” which, among other things, restricted investors from shorting stock by selling forward shares they didn’t currently possess.

And so, the legislation train has been rolling on through the centuries. Governments typically introduce bans on short-selling in the wake of financial calamities only to later lift them as the public consciousness fades.

Many investors, both past and present, have questioned the morality of short-selling. That is, is it fair to profit from another’s loss?

To me their case is ill-considered. As a counter argument, simply reflect on how most other people hope to make money in the sharemarket – that is to buy low and ultimately sell high. Have they not profited at the expense of another? Has not the person or people who sold given up profits (to the buyer) that they might have otherwise received?

It seems that when people are making lots of money in a rising market there is no concern about short-sellers. Yet when the market turns south everyone is seeking scapegoats and short-sellers are an easy target. After all, they are the ones who are grinning when everyone else is feeling pain.

The final word

First, retail investors are allowed to short sell. But it takes effort, a solid understanding of the process and involves way more risk than a simple buy-and-hold strategy. So, if you are interested, do not just jump in. Do lots of homework, engage a good broker and please take baby steps.

The Australian Securities & Investments Commission (ASIC) publishes, on its website, a regularly updated list of Australian companies that are “being shorted”. What’s more, it details the percentage of the company’s shares that are. It’s called the Short Position Reports Table and contains some interesting information.

About the author

Michael Kemp is the chief analyst for the Barefoot Blueprint @Bareftblueprint and author of ‘Uncommon Sense’, published under the Wiley label, which delivers a considered and logical approach to the complex world of investing.

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