Short selling. If you didn’t immediately vomit at the term, perchance you shat yourself instead. Short sellers, as a breed of investor, are generally not well-liked.
You’re betting on the demise of this sweet and innocent stock? Where’s my whipping stick…
But just as not all companies are ‘innocent’ — whatever that means in the kidney-punch that is the year 2024 — many might agree not all short sellers are ‘bad’. The more virtuous among them are actually capable of acting as a force for good.
“One thing I will say for short sellers is that many of them really do believe their (standard, correct) claims about their role in financial markets: that they make markets more efficient, deflate bubbles, root out fraud and delusion, and generally make the world better with their unpopular and negative activity,” Bloomberg columnist and former Goldman Sachs banker Matt Levine wrote in 2018.
“They see it as a noble but misunderstood calling.”
What is short selling?
Before we go any further, it’s perhaps a good idea to establish what short selling is, exactly.
The simple explanation is that shorting is a method of profiting from the decline of a company’s share price.
Here’s how it works: Borrow the shares from an existing investor who owns them and sell them to someone else. After a period of time, you return to the market, buy the shares back, and deliver them to their rightful owner. All things going to plan, you will have bought the shares back for less than you sold them, and the difference — minus the usual broker fees and whatnot — is your profit.
What is naked short selling?
While short selling is perfectly legal in most countries, its shadier counterpart — naked short selling — is not.
It works much the same way, except you sell the shares without first owning, borrowing, or securing the right to borrow them. In other words, no one can guarantee those shares you’re shorting actually exist, even though there is a sell order for them. The plan is to borrow those shares at a later date to deliver them to the buyer.
For a number of good reasons, this is a problem. Indeed, the seller might not be able to find shares to borrow, which results in a ‘failure to deliver’ and presumably a few sleepless nights. Such a failure to deliver can affect the liquidity of the company’s shares, artificially depressing their price in the process. It can also subvert the supply and demand dynamics, making trading in certain securities unfair and untrustworthy.
“He who sells what isn’t his’n, must buy it back or go to prison”
In Levine’s estimation: “He who sells what isn’t his’n, must buy it back or go to prison.”
One of the most prominent examples of naked short selling — and its perils — is the collapse of Lehman Brothers in 2008. Data from the US Securities and Exchange Commission at the time showed more than a 57-fold increase in failures to deliver of Lehman Brothers shares compared to 2007.
Although the investment bank — the world’s fourth largest before its demise — played a key role in the subprime mortgage crisis, Lehman CEO Dick Fuld testified before US Congress that naked short selling had precipitated the company’s downfall. However, various analyses in the years since have found otherwise.
The notorious trading practice was then largely banned in the US and European Union following the 2007-2008 global financial crisis.
What is predatory short selling?
Another sinister alternative to regular short selling is the ‘predatory’ kind. Not so much a mechanism as a strategy (naked short selling, for example, would also qualify as predatory), it’s the organised chaos of legal trading.
Predatory short selling works the same as the standard, legal kind, except intentionally manipulative tactics are deployed. This can include strategic orders for many small, last-minute trades — rather than a few large ones — designed to suppress closing share prices, which often leads to broader market repercussions.
Junior companies can be particularly susceptible to the effects of these trades. So much so that Power Nickel (TSX-V:PNPN) CEO Terry Lynch has launched a group called Save Canadian Mining, with the intention of drawing attention to and combating the problem, particularly as it relates to the removal of what is known as the ‘tick test’.
The mechanism had been in place to restrict short selling activity by only allowing short sales at a higher price than the most recent trade. But in 2011, the Investment Industry Regulatory Organisation of Canada (IIROC) published two studies that found the tick test, or ‘uptick’ rule, had no appreciable effect on share price movement. The regulator instead noted that it used other mechanisms, such as real-time alerts, to address abusive short selling activities.
As a result, the tick test was removed in 2012 in accordance with a package of new policy and surveillance initiatives intended to — ironically — strengthen Canada’s regulatory regime.
“These changes were applied not only to the main listing venue of (the) TSX Venture Exchange, but are equally applied across all Canadian trading venues, of which there are 14 today, reducing TSX Venture’s ability to effect any change,” Save Canadian Mining’s website says.
“Since removal of the tick test, the Canadian markets have evolved, and there now exists a dynamic where short selling activities, high frequency trading, and algorithms are exploiting the lack of a tick test to the detriment of Canada’s junior markets. We call on CSA and IIROC to evaluate re-instituting the tick test.”
Some of Canada’s biggest names in mining have backed the movement, including billionaire investor Eric Sprott, McEwen Mining (TSX:MUX) Chairman Rob McEwen, First Majestic Silver (TSX:AG) President and CEO Keith Neumeyer, and Osisko Development (TSX-V:ODV) Chairman and CEO Sean Roosen.
What is a short squeeze?
A ‘short squeeze’ is a particularly interesting market phenomenon. Again, its underlying mechanics are just the same as regular short selling, but the difference is a matter of scale.
When a certain stock is exposed to a significant number of short positions, but instead of declining as predicted the stock goes up in value, a strange thing happens. In an effort to minimise their impending losses, short sellers go nuts trying to close out their positions. The effect is not unlike taking a cattle prod to a rhinoceros; the share price charges — inexorably, unstoppably, in defiance of all logic — sharply upward.
Perhaps the most well-known example of this is the ‘meme stock’ frenzy of 2021, which primarily involved Gamestop, but also a number of other then-struggling US companies.
For some time, Wall Street funds — short selling fanatics of the truly highest order — had been gathering weighty short positions in Gamestop, betting that the Blockbuster of the gaming world would continue its downward trend. Usually, these funds are not obliged to disclose their short positions, but a handful of retail traders, conspiring together in corners of the internet like Reddit’s WallStreetBets forum, made a key discovery.
Melvin Capital Management, for example, held ‘listed put options’ to the tune of US$55 million ($81 million). Hooked by the mere whiff of opportunity, the retail traders began buying up both Gamestop shares and call options, thereby putting the brakes on their downward slide and giving the stock its first reason in a long time to actually appreciate in value.
Only a few months prior, Scion Asset Management’s Michael Burry (of The Big Short fame) published a bull case for Gamestop, suggesting the company could be turned around in a couple of years and return to profitability. The retail hordes quickly latched onto the report, pouring yet more petrol on the fire.
The squeeze on Melvin, combined with an unprecedented surge in retail investment, sent Gamestop’s shares blowing past their all-time high, gaining some 1,700% in a matter of weeks. Meanwhile, Melvin, unable to execute its short, lost more than US$2 billion, and had to rely on bailouts from Steve Cohen’s Point 72 and Ken Griffin’s Citadel funds.
So, what to do with short sellers?
All of this begs the question: What, if anything, can be done to negate the effects of short selling, predatory or otherwise?
Do many have the stones to answer that themselves? Probably not. But once again, Levine has no qualms.
“If you are a public company chief executive officer and your main goal, or even one of your top five goals, is punishing short sellers, then you have already lost. That’s a terrible goal!” he wrote last year.
“The way to deal with short sellers is to run a good business that makes a lot of money; this will make your stock go up, and the shorts will take care of themselves. Short sellers don’t matter! They can’t hurt you! At most, they can make your stock go down a bit, but your business does not depend on your stock price; your business depends on your business. Just do your business! Ignore the shorts.”
There are, he adds, two exceptions to this. Maybe you’re a bank, in which case ‘consumer confidence’ is a big part of your business, in which case a declining share price could indeed be a problem.
The other is that your business might just be a pump-and-dump scheme.
“‘Just run a good business’ is absurd advice when your business is putting out press releases to make your stock go up, and it does make sense that you would be laser-focused on fighting short sellers,” Levine adds.
Many other schools of thought would suggest otherwise, and many of them will surely be correct in various ways. Not to mention the fact that short selling, believe it or not, runs even deeper than that examined here; gets even weirder somehow. But for the avoidance of foolishness or just plain masochism, perhaps that’s better saved for another day, eh?
Images: NASDAQ, Unsplash
