Short Selling

When the price of something falls, stakeholders look for someone to blame. Is it right to look at short sellers?

Dear Alice,

'The recent financial crisis has apparently been caused, partly, by 'short selling'. What is short selling and to what extent is it to blame for the mess we all find ourselves in?

At this rate I will be abandoning my plans to become a city trader in pharmaceutical stocks and revert to the idea of becoming a doctor.'

Claire

Medical Student, Imperial College

Dear Claire,

If I was to have a conversation with one of my city girlfriends about the merits of going 'short' they would assume I was about to step out with a gentleman less than 6'4" in height. Not something I am renown for doing. They would be writing letters to agony aunts on my behalf.

However, these are desperate times, and desperate times call for desperate measures.

So just as there is a lot to be said in the dating world for going short and dating a man who is 5'10" if he more than makes up this with his sparkling wit, fabulous wealth and physical prowess in other areas, so if the markets are falling there are reasons to not only sell what stocks and bonds you own, but even to sell some more you don't own.

This practice is known as "short selling" and it has come into the media spotlight in recent weeks because the short selling of financial stocks has just been banned. Now the media decries anyone involved in short selling as the financial equivalent of a child killer and has blamed the speculation that is seen to go hand in hand with short selling for a good proportion of the world's market woes.

Being long

In the financial world 'being long' means buying stocks, shares, commodities and other instruments in the belief they are going to go up, and holding them for the long term until they do.

Anyone 'going long' is seeking to benefit from a rising market. When markets are going up, as they have done for the most part of the last 25 years, the majority of investors will be 'long'.

Over time, most asset prices tend to rise, on account of increasing productivity, advances in technology and other forms of general progress, so it makes sense that, over time, prices and values rise.

So 'being long' is the norm.

However, as we have seen recently, markets do not rise inexorably, still less smoothly and without periodic corrections.

A strategy for falling markets

Since last year the FTSE 100 has fallen from a high of above 6800 to below 5000. That's a fall of more than 20% - one of the definitions of a 'bear' market.

So what is the investment strategy for troubled times and falling markets?

When the market weather is inclement, most investors will seek 'safe havens' - financial ports in a storm. It is generally held that certain sectors offer better downside protection in falling markets and these tend to be associated with human staples - food, drink, tobacco - and until recently, retail banking. In other words, activities that have to go on no matter how strong or weak the economy is.

The ultimate safe havens are government bonds - 'gilts' and treasury bonds - and physical commodities with high intrinsic value - like gold and other precious metals. The view here is that governments cannot go bust, while the value of physical assets is not an ethereal concept, unlike that of financial assets.

Investors will also 'go into cash' - that is liquidating their investment positions and holding cash on deposit in banks and building societies. However, this is not a riskless position. As we have seen recently in the cases of Northern Rock, HBoS and Bradford and Bingley, retail banks who receive savers' deposits can run into trouble if they suffer a run of withdrawals or suffer losses from their wider activities, while the value of money will always be eroded by inflation.

Furthermore, retail investors do not pay investment managers high fees to stay in cash for long - they can do that for themselves.

So what if you, or your fund manager, want to go further and actually profit from a falling market? How do you it?

The answer is to 'go short'.

How does short selling actually work?

Going short is the opposite of 'staying long' - something I always insist on in a man no matter what his height.

What is 'going short' and how does it work?

Going short involves selling stocks that you hitherto never owned at the prevailing market price and then waiting for them to fall in price, before buying them back in the market at a new lower price.

But how do you sell something you don't own?

The answer is that you borrow whatever you are selling from someone who is in the business of assisting with such contracts - in the case of shares, a stock lender. Most investment banks have stock lending departments and they source stock to lend from long-term investors who want to earn a little extra return from their long-term positions.

The stock-lender lends the short seller the stock to fulfil their sale contract.

An example

The order of play in a short selling transaction goes like this:

1. The short seller identifies a stock that is likely to fall and decides to go short in it

2. The short seller contacts a stock lender and agrees to borrow a certain amount of stock for a certain length of time in return for a fee

3. The short seller than sells the borrowed shares in the market at the prevailing price

4. The short seller now waits and hopes that his view that the stock would fall in price is vindicated by the market, before the time comes to return the shares borrowed to the stock lender

5. If he is right, once the stock's market price has fallen, the short seller will buy back the same shares in the market for a lower price than that at which he sold and then return the shares to the stock lender, clearing his borrowed position and calculating his profit

6. Casting an eye over the entire transaction, the stock lender fulfilled the golden market rule - buy low / sell high - he just did it the other way round

7. His profit is the difference between the buy and sell prices, less the stock lending fee.

Other uses of short selling

Short selling is often used as a hedging technique or as an arbitrage technique by hedge funds.

My last article in the previous issue of The Gateway [Issue 9, Pages 16-17] on the strategies of hedge funds explained how sophisticated investors will often pair together long and short positions to mitigate excessive risk and confine an investment position to purely the event on which the trader wants to bet - like whether a merger announcement will complete or not.

In M&A arbitrage, a trader will often simultaneously buy the target company's shares and sell the acquirer company's shares. He will then make money if the merger completes irrespective of how the rest of the market performs in the meantime.

Is short selling bad?

In my view, no, it's actually good thing, especially if properly regulated.

It is a legitimate technique that plays a vital role in making markets more efficient. If investors can only go long there is always going to be more upward pull than downward push and that is not healthy in discovering what should be the true level of market prices.

Also, as I have discussed above, short selling provides a useful way to mitigate risk.

It is true that falling stock prices can be highly detrimental to a company's real life operating performance. Its ability to raise money in the equity capital markets will be severely restricted as no investor will want to buy something whose price is falling. Without expansion capital, its operating ability will be impaired and it may fall prey to a takeover.

Public companies always get a lot of press coverage and it is only natural that consumers associate good products and services with a company whose stock price is rising. If a company's stock price is falling, consumers naturally assume there is rational reason for that, and shy away from given it their custom. This creates a downward spiral from which it is hard for a company to emerge.

As ever, when the price of something falls, stakeholders look for someone to blame. So it is easy to look at short-sellers as the major cause of falling prices, when usually this is not the case.

Most of the time, falling stock prices are not due to short selling, rather by just plain and simple selling of previously held long positions. If a stock price is falling it is due to either fundamental or speculative reasons. The former should always ultimately prevail over the latter, so eventually a company's share price should always lie at its true fair value.

Even if the share price of a company is driven down by short selling and that company is, in reality, healthy and producing strong cashflows, rationale will soon prevail and other investors will enter the fray to buy the stock which by then will represent good value.

How could short selling be regulated?

So what regulation might be necessary to ensure that short selling is a good and not a bad thing? There are historically two main devices used to moderate short selling, although both come with in-built defects...

First, the amount of shares sold short in a particular company is limited to the number of shares in issue by that company. So a company cannot be sold short for more than itself. However, this rule is made irrelevant by virtue that traders do not have to buy or sell the shares themselves of a company to make a bet on its future value. They can use derivatives such as standard calls or puts or contracts-for-difference (CFDs) and such transactions being 'over-the-counter' (OTC) and not exchanged-traded (ET) will not fall under the spotlight of a stock-market, and hence will escape regulation unless it is also made a requirement - as it might be - that all derivative contracts are registered with a stock exchange.

The second suggestion is that traders can only sell short after a price uptick. That is, they can only sell when the last price change in a company's stock price was up. To me, this seems rather nonsense. There is no equivalent rule whereby you can only buy shares if the last price movement was downwards. If the market wants to price something down, why shouldn't it?

What's the Bottom Line?

The bottom line? In my view the market needs short selling. Either we have capitalist free markets or we don't. If we do, we want those markets to be efficient and fast-acting. We want the correct level of prices to be discovered quickly so we can respond with appropriate investment decisions. Short selling speeds up the price discovery process. It offers useful hedging and risk-mitigation devices and guards against a phenomenon just as damaging as fast-falling markets - that is run away bull markets.

So going short can be good. My current suitor certainly proves that.

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