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Short selling 101 – How does it work and what’s all the fuss?Experts
September 15, 2022 |
Nadine McGrathshare- Short selling is a mystery to many investors, so how does it work, who are key players and why do they do it?
- Short selling is selling something that you don’t own hoping to buy it back at a lower price in the future
- Hedge funds typically do the majority of short selling using a variety of strategies to determine trades
Arguably the most famous short seller of modern times is hedge fund manager Michael Burry, who in 2005 discovered that the US housing market, based on high-risk subprime loans, was extremely unstable and forecast it would collapse in 2007.
Burry saw the riskiness of the subprime housing market as millions of US borrowers with low income, no assets were able to buy homes with enormous leverage and would be unable to make repayments when interest rates increased.
Long story short, Burry made a whack of cash (reports of US$100 million for him personally and US$700 million for investors) by shorting the US housing market which led to the 2007-08 financial crisis by convincing major investment firms to sell him credit default swaps against subprime deals he saw as vulnerable to default.
Burry was a key player in Michael Lewis’s book
The Big Short:Inside the Doomsday Machine which was turned into Hollywood movie
The Big Short. Short selling 101Each month at
* we write an
article on the most shorted stocks on the ASX. But what exactly is short selling and why all the fuss? In the first of a
two part series we will look at what is short selling and why some stocks will be targeted.
With more than 30 years experience working in financial markets, including State Street Global Advisors, Goldman Sachs JB Were, Australian Banks and now consulting, Mark Wills has extensive experience with short selling.
“Short selling is simply selling something that you don’t own hoping to buy it back at a lower price, while going long is buying something you didn’t own and hoping the price will rise over time,” he said.
“The word ‘short’ is used to denote when an investor has a negative exposure to an asset and being ‘long’ indicates that an investor is positively exposed to an asset.”
Wills said shorting typically is done by investors in the professional market because the activity requires a level of operational skill that individual investors may lack.
“Investors who tend to do most of the short selling are typically classified in the alternative bucket of asset managers, usually hedge funds,” he said.
Short selling strategiesWills said hedge funds will use a variety of strategies for shorting selling a stock including:
1. Event Driven – Investors seek to exploit mispricings caused due to different corporate actions, mainly takeovers.
“When a takeover is announced the underlying stock can often become overpriced,” Wills said.
“The manager will short the stock with the expectation that the share price will fall either because the takeover fails to be completed or the takeover goes through at a lower price.”
2. Long/short or market neutral – Wills said a long/short manager have a neutral position and will buy a stock or stocks, and short an equivalent value of a stock or stocks against that position.
“At anyone time their fund or positions should total zero hence the term market neutral because they want to avoid exposure to the broad market,” he said.
“Often this is done within a sector for example one bank versus another bank or one bank versus its sector.”
“Sometimes one stock within a sector can be extremely cheap versus all the other stocks in the sector so the manager will short the sector via an ETF versus a long position in the under-priced stock.”
He said another variant can occur at the entire sector level versus the index; for example often tech stocks can become extremely expensive versus its index.
“In this case the manager will short the stocks in that sector and buy either a market-based ETF or an index future.”
3. Volatility traders – Volatility traders take positions using options depending on the level of volatility impounded in the options prices.
Options trading enables investors to speculate on the future direction of the overall stock market or an asset.
“If the options are cheap then the manager will usually buy the options and sometimes short stock to hedge their position,” Wills said.
“If the manager sells options short then they will often buy stock to hedge.”
Settling a short saleIf you short any asset, then you need to settle the deal. In other words, fulfil the contractual obligations of the transaction.
“If you sell an asset that you own then the delivery versus payment (DVP), an industry standard term for settlement, occurs,” Wills said.
“You deliver the physical asset, even though it is a form of electronic record versus the receipt of cash.”
So, how do you settle a trade if you don’t own the asset? Simply, Wills said, you borrow the asset.
He said the lending of assets is managed under stock lending programs which are offered by the large asset custodians, which as their name suggests holds assets under custody for the owners.
“The stock lending industry grew out of a demand for assets to settle trades for short selling,” he said.
“Asset owners agree with their custodians to lend stock and receive a fee in return.
“Specialist brokers manage stock borrowing on behalf of their hedge fund clients to facilitate the settling of short sales, and the hedge funds pay a fee to borrow stocks.”
Hedging against own short positionsWills said stocks that are in special situations attract a higher lending fees with stock lending programs operating like any other market and some assets being more valuable than others.
He said examples of special situations can be a sector under heavy demand like oil and gas stocks currently due to the Russia-Ukraine war.
“Speculators drive the price up well above an asset’s fundamentals and specialist hedge funds react to this by short selling these stocks,” he said
He said hedge funds operating in the market are also buying stocks as a hedge against their own short positions.
“If they short BHP and buy RIO it will be for an equivalent value when the trade is instigated,” he said.
“They are often injecting the same amount of long positions as short positions because they need it to be hedged.”
The hedge funds who engage in these specialist types of asset management are looking to exploit shorter term market abnormalities. The broking community refers to them as ‘fast money’ as a general client segment. Traditional asset managers are called ‘real money’ clients.
“The broking community acknowledges the difference in style and how they describe clients,” he said.
“A traditional active long-only manager aims to generate excess returns above an index benchmark whereas a hedge fund (because they are indifferent to the overall direction of a market) will look to generate an excess over the cash rate.”
Good chance you’re exposed to short sellingWills said there is nothing magical or sinister about short selling and most people are exposed to short selling through their superannuation.
“If you are personally invested with a typical superannuation fund then it is highly likely your money is allocated to a) active long-only managers both domestic and international, b) hedge funds who engage in short selling and c) generating income for the fund through a stock lending program,” he said.
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