Short selling – end game guide

Profits used to come from the value or worth of an asset going up in price. Investing or Going Long is the traditional buy and hold. If, however, you want to trade Volatility instead of just Value or Worth, then you need some mechanism for making a profit from the other half of market movements – the downward side. That is where Short Selling comes in.The Short Seller profits from prices going down. Once you can do that, then you can trade in volatility and there is much more profit to be made from volatility than there is from old fashioned ‘value’. (For what I mean by trading Volatility versus Value, please refer back to “Volatility – The Market God” 7th May).

So how does Shorting work?

The Short seller borrows a stock, share or asset with an agreement to return it on a specified date. The Short then sells the asset. His gamble is that the price is about to go down. If it does, he buys back the asset for the new, lower price, returns it as agreed and pockets the difference between what he sold it for and what he re-purchased it for. Of course if he was wrong and the price went up, he still had to buy it back to return it, but he makes a loss.

That’s it.

So is it good? Well let’s look at each player.

It’s all good for the Short seller. Obviously. The Broker who holds the shares for the owner, lends them to the short seller and brokers the agreements and sales, makes commissions. What about the owner of the stock? If you see long and short sellers as opposite then it seems perverse for the Long term investor to lend his stocks out to Shorts who want to bet the assets are going to lose in value.

But actually Shorting can profit the Long Term investor as well. You see, if you own a stock it might be gaining in value or it might not, but while in the process of gaining or losing, you are just waiting for the outcome . If, on the other hand you lend it out, via a broker, to a short seller, you get a fee. It’s a small fee, but if you’re a pension fund, for example, you might have millions of shares to lend. The income you get from lending them out, makes you an additional profit, when the shares go up and offsets a little of any loss, should they go down. And it gets better.

Imagine a stock gyrating up and down by increments over the weeks and months. At first the downs are a little bigger than the ups and the general drift is down. You have made a loss, offset slightly by having lent out your stock for short sellers to borrow. But now, over the next few weeks, the ups are larger than the downs. And after 6 months you are back where you started. Had you not lent out your shares you would have earned nothing but by lending them out for shorting, you profited the whole time from fees. That is why owners lend stocks out to short sellers.

The short, obviously only makes money when the shares go down. You make money both ways. Of course then Short can still make money even in a rising market he just has to chose more carefully.

You could ask, why don’t the owners just buy and sell their shares themselves, and cut out the silly short person. The answer is one of scale. Owners tend to be huge – pensions, funds or all sorts. They could pay an army of people to buy and sell. That would cost a fortune in salaries. Why not earn the fees and let the short sellers risks take the risks? Shorts are like the little fish who clean the algae from the skin of the bigger fish. This works, of course, so long as the little fish stay little. It turns inside out if the shorts become too large.

The only replacement for shorts is HFT trading which does the short sellers out of a job. Computers could make human short sellers a thing of the past. And becomes far too large.

But for now, Shorting can be profitable for all. But is it ‘good’ for the markets and for the rest of us. Does it make the market less stable?

The defence of short selling is that it provides liquidity and it keeps prices more closely matched to what people think shares are really worth. It avoids huge numbers of shares just squirreled away in accounts, out of contact with the market and therefore not being priced in the market. Short sellers will argue this can lead to prices getting dangerously detached from their real value, as owners refuse to sell, only to see values suddenly thump down when some big owner cuts and runs. That’s the argument. Never heard the actual example of the stock value which was so out of whack. So the price matching argument seems a little thin to me.

As for the liquidity argument, everyone and their auntie claims to be the provider of market liquidity until there is a liquidity crisis and then everyone looks at everyone else and says, “I thought you were bringing it”. Shorts provide liquidity when there is already lots about – when the market is bobbing up and down healthily and there’s no shortage anyway. When the market is crashing down, shorts do nothing to ease or stop the wreak.

Which, mention of ‘worse’, brings us to the charge often made against shorts and shorting, that it makes crashes worse or even causes them. The easy refutation often heard is, ‘How can shorts force a price down? They are only responding to other people, long term owners, who choose to sell at a lower price’. Well this is true as far as it goes.

Remember we are taking about a market that is trading in volatility not in longer term estimations of underlying value. Whether the trend of the stock is up or down, shorting can make profits. All you need is volatile ups and downs. The key point is to remember that market players are trading in volatility.

Now in a boom market the ups and downs, are all in an overall upward trend. In a ‘normal’ market the trends of a company, its real health and profitability will have the last and final say. Shorts could borrow as many shares as they liked but no one would sell if they didn’t want to. But now imagine a falling market. One where market factors such as over all indebtedness, shortages of financing etc hang over all companies good and bad. Remember traders are paying a lot of attention to those shorter term volatility fluctuations.

In this more febrile market imagine someone borrows a lot of shares, or worse naked shorts – which means they haven’t actually borrowed the shares they are shorting. And add to this people buying CDS contracts betting a particular share is going to decline. The market sees those short bets, borrowings and offers to buy at lower prices. If you’re in a rising market you can ignore them. But in the fevered atmosphere of a falling market, a seriously illiquid or insolvent market, you might feel the pressure. The short sellers actions and offers become signals. They can be read as indicators of what players expect is going to happen. If they are big players making big bets can you afford to ignore them?

Do you sell at a low loss and cover yourself against larger losses in future, that others seem to think are coming? Or do you play long and ignore them? Well the larger those bets get the more smaller players will feel they need to sell and cover against larger losses. And anyone who is has simply got sell for reasons of their own – they have debts they have to pay-off and need to sell to raise cash, for example – they will read a large interest in short selling as a spur to sell quicker and settle for less just to get the needed cash before any further decline. Those’ not quite forced, but ‘enouraged’ sales add to the momentum of shorting. As a strategy you could even buy a chunk of stock you were shorting or intending to short, sell fast at a small loss, hoping your sale adds to the downward momentum, and makes your much larger short position much more profitable.

So shorting, while profitable and benign in a ‘normal’ market can be used very destructively as an accelerator in a falling market.
Naked shorting makes this sort of pressure play much easier.

I would like to add however, that to single out shorting in this way misses a larger point. Shorting is speculation rather than investing. Just as much damage is done by speculation that drives prices up as shorting does driving them down. Both are symptoms of how the markets have altered, moving away from investing and helping businesses and people over the long term, towards speculating and preying upon them for short term gains.

We are currently in the grip of a self-consuming speculative end-game where nothing can be built up before it is torn down. Where speculators could care less about your tomorrow, because their ravenous hunger for profit today, is all that matters.