Freshly Squeezed 🍊
a deeper dive into short selling
This is a continuation of my previous piece, an introduction to short selling
I might as well continue where I left off, with Bill Ackman’s noble quest to end the tyranny of Herbalife’s “pyramid scheme”
Bill Ackman was beginning to sweat, Carl Icahn had decided to take their historical beef into the markets, and he was twisting the knife sharply. Bill’s firm Pershing Square was shorting HLF to the tune of $1 billion, and had successfully begun to drive the share price down to $34 after several high profile presentations and media appearances. Carl’s entrance with a ‘small stake’ (which eventually ended up at over 26% of Herbalife) however, began to turn the tide, and eventually rocketed the price close to $100, successfully squeezing Bill’s humongous short, and forced Pershing to close their positions to extreme (and still undisclosed) losses.
Short squeezes are the biggest risk that a trader faces when opening short positions, despite all of the science that analysts attempt to employ, the markets are still easily swayed by emotion, and it doesn’t take much for a rumour (or a tweet) to drive the price of a stock higher or lower. If a stock you are short on puts out some good news that motivates the bulls, and the price begins to rally, you may have no other option but to buy the shares back at whatever price you can, which in turn then inflates the price even further in the process!
Now you may be feeling brave, and think to yourself “I can weather this storm, this ship is going down!”, that’s great! But unless you are, in fact, Bill Ackman, your broker may disagree. If you do not have a sufficient rainy day fund, you may be issued with a margin call, where you are required to deposit cash or close other positions in your account to satisfy your broker’s concerns that you can cover your losses, as you are betting using cash that technically is on loan (margin!). If you don’t have the cash available to satisfy your creditors, despite how much you argue the logic of your position, the likelihood is that the broker will close your short, and leave you with a hefty bill to pay.
Anyway, enough of poor old Billionaire Bill, let’s focus more on us mere mortals. Say you put your middle finger up to Elon’s “funding secured” tweet and decided to short Tesla, and less than two weeks later the price is down 20%, you know how volatile this stock can be, so you decide to take your winnings and run. In order to cover your short, you need to go back into the market and buy the same number of shares you borrowed, so that they can be returned to the original owner. This sounds easy in practice, but bear in mind there may be a bunch of other traders trying to do the exact same thing (TSLA has been one of the most shorted stocks ever, remember), so the rush to cover shorts may, in some circumstances, end up triggering a rally, due to the increased demand for the shares.
Shorting is a much more hands on activity than investing, so it’s advised that you always keep your finger on the pulse of the market, and be ready to close out at a moment’s notice, or else you could be the victim of potentially unlimited losses. This is where the short interest ratio becomes an important data point. Stock exchanges typically report the short interest in listed stocks monthly, which is a simple way of measuring investor sentiment. Sticking with Tesla, the short interest currently stands at just over 20%, meaning that a fifth of the companies shares are currently loaned out to those holding short positions. To work out the short interest ratio, we take the number of shares sold short and divide this by average daily volume (34,057,205/11,748,424= 2.898874). The reason why this number is important is that it tells short sellers how long it will take them to cover their shorts in the event of a rally, if Musk pulls another rabbit out of the hat and the share price takes off, it will take all of the shorts nearly 3 days on average to buy back enough shares to cover their positions. So, going back to our earlier example, say if on the 20th August when the price was down 20%, all of the Tesla shorts thought they would cash in their chips, in the 3 days it may have taken them to buy enough shares back, the price had already rallied back up 9%, significantly reducing their profits! Poor bears.
Short selling may sound slightly nefarious, after all people are trying to capitalise on bringing down the value of companies that they are shorting, but the practice serves a vital role in ensuring fair markets, helping to maintain fair valuations and clipping the wings of those that fly too close to the sun, or are actually committing illegal acts.
Unfortunately however, there are those that don’t engage in the activity for the good of the markets, and actually seek to devalue innocent companies by employing unsavoury tactics such as smear campaigns, flooding the media with fabricated reports or rumours to bring the stock price down so that they may realise a profit. This is the opposite of a pump and dump scheme — but with an equally catchy name: short and distort.
One of the most famous short and distort cases was that of Anthony Elgindy, or as he has been referred to, The Mad Max of Wall Street. This guy sounded like a really bad egg, originally being part of the other team as a pump and dump’er, he rebranded to Tony Pacific and began a lucrative operation in the short selling business, attempting to devalue companies that he believed were engaged in illegal activities. Tony built up quite a reputation in online forums, eventually gaining enough notoriety that he could drive stock prices down by his posts, once he realised he could monetise this power he set up a firm called Pacific Equity Investigations, charging users a monthly fee of $600 to receive his picks of stocks to short. What started with publishing fake news about his picks turned even darker though, he made friends with an FBI agent and began using inside information about pending federal investigations to gain an advantage, he would even use this information to allegedly extort executives out of money to prevent him from distributing the news to his subscribers. Eventually he was brought to justice, but for crimes related to his FBI connection, rather than his short and distort scheme, you can view a video about his story here.
Short and distort schemes have proven very difficult for businesses to tackle so far, as they are usually targeted at smaller companies where the share price is easier to manipulate, and where they are less likely to have the resources to fight back. Another issue has been identifying the criminals, as the false statements/reports they are generating are published on the internet through blogs and message boards, the authors have found it much easier to mask their true identities, preventing prosecutors even being able to bring suits against them.
I’m sure most of you reading this will never engage in short selling, it’s a risky business that usually only institutional investors have the appetite for. It’s capital intensive and can expose you to large potential losses, but as I mentioned, the practice provides a valuable service within Global markets, keeping valuations within the stratosphere and exposing the dark side of business. Just remember that short sellers unearthed the Enron scandal, the mismanagement at Lehman, even Herbalife, the case I’ve referenced in both of these articles resulted in penalties of $200m, even if the short itself was regarded a failure. Of course there is money to be made if your bets are right, but sometimes a company needs to be outed for it’s wrongdoings, and should be made to pay. ✌🏼