Over the last couple of weeks, short selling has been in the news quite a bit.
The frenzy around GameStop (GME), AMC (AMC) and some other "meme" stocks was, in part, due to online conversations about a ‘'short squeeze'.
And while that particular bit of excitement seems mostly to have passed, the age old practice of shorting is continuing to grow in notoriety as investors aim to become more aware of what shorting is and how it works.
What is Short Selling?
A short sale is an investment where instead of rooting for the price to increase, the investor banks on the price of a security going down. Think of the investing adage of "buy low and sell high", a short sale is the same basic strategy, except the order is reversed: "sell high and buy low".
The way this works is the investor borrows shares of stock and sells them at the market price. When the shares fall, the investor can repurchase the shares for a lower price to return the shares borrowed.
This strategy does have some unique risks though. Since there's a hard cap on how far a stock price can fall (Stocks don't trade in negative numbers), gains from short selling are capped. Meanwhile, the investor has to pay interest on the shares they borrowed, and that interest rate can get higher based on how many investors want to short the stock. Meanwhile, since there's no limit to how high a stock can go, losses are potentially infinite.
Because of the need for borrowing, and the potential risks, short sales can only be made in a margin account.
What is a Short Squeeze?
In addition to carrying risks from simple gains in a stock's price, short selling also stands to be hurt by more uncommon phenomena called a short squeeze. This occurs when the price of a stock is rising, causing the short seller to face increased borrowing costs. When the short seller goes to close the position, they have to buy the stock, which can push the price up even higher. This can become particularly exaggerated in cases where the stock is thinly traded or if short interest is particularly high.
This is what happened in the case of GameStop, which famously soared as investors banded together to buy the stock. This forced investors with short positions to buy the stock at higher and higher valuations in order to close out their positions.
How Can the Short Float Percentage Be Greater than 100?
In the Gamestop situation, investors on the long side pointed to a metric known as short float percentage as a reason to suspect short sellers of doing something illegal, such as naked short sales. To understand this number, you need to understand a few other things:
Float: This is how many shares a company has that are available to trade.
Short Interest: This is how many shares of the company are currently held short.
Short Float Percentage: This is the Short Interest, divided by the Float.
So, if float is the number of shares available, how can the short float percentage be greater than 100? Wouldn't that mean more shares were sold short than are available to trade?
Not really.
For every short seller, there is a buyer... but actually two buyers. A person who bought the stock and lent it to the short seller, and then another person who bought the shares as they were being sold short short.
Imagine Company A has 1,000 shares available for trading. Mark has 500 shares and Mary has 500 shares.
Mary lends her shares to Matthew, who sells them short to Mathias.
The short float percentage is now 50% as there are 500 shares sold short, but only 1,000 shares issued.
However, a metric that we'll call Long Float Percentage has now risen to 150% as there are 1,500 shares held long, against 1,000 shares issued.
Along come Mason, who also believes Company A's stock is too high. He borrows 500 shares from Mark and sells them short to Mohammad.
Short float % is now 100 (1,000/1,000), while Long Float has risen to 200% (2,000/1,000).
And, there are still 1,000 shares available to borrow for Millie, Milo and Madeline to sell short to Magnus, Monty and Miles.
Is Short Selling Bad?
Short sellers are frequently blamed when a stock falls unexpectedly. Companies often accuse short sellers of driving their share prices into the ground. Any time short selling is in the news, there are often calls to ban the practice.
There is an already illegal process called a bear raid, in which short sellers coordinate their selling, often spreading false rumors to try to drive a stock down.
However, short sellers occupy a special role in markets that helps keep fraud from thriving in financial markets. Those in the business of profiting from failure tend to search high and low for evidence that a company is not all that they say they are. By doing this, short sellers profit handily by shining light on shady parts of the market, famously bringing down the likes of Enron and others engaged in fraudulent practices.
During the past year, the electric vehicle industry has provided us with a great example of shorts done right and wrong. Tesla (TSLA) and Elon Musk came under fire by short sellers who swore Tesla stock did not justify the valuation. However, Musk and the company remained calm, sold short shorts to antagonize the short sellers, and fell 450 cars short of an ambitious goal to deliver half a million cars during the year. These short sellers lost $40 billion dollars and are the only people who had a worse 2020 than the airlines.
Meanwhile, short seller Hindenburg Research took on up and comer Nikola (NKLA). After publishing a long piece outlining the alleged fraudulent acts made by then CEO Trevor Milton. The firm accused Milton of lying about the company's technology, which had landed NKLA a well-publicized deal with General Motors. After the release of this report, Milton resigned from his position which was then filled by former GM executive Stephen Girsky, and the deal with GM was renegotiated.
While the GameStop squeeze was fun for retail investors, the result of it has been that some companies will no longer share their research on companies that they think are failing, and will turn their focus to stocks worth buying. While this seems like a win for retail investors, it also means that they will no longer have potential bearish opinions to take into consideration when making a trade. This creates a less informed trading process and opens the door for retail investors to unknowingly fall victim to fraudulent businesses.
