For Elon Musk And Others: How Short Selling Works

Understanding a misunderstood investment concept

I “Reddit” on the internet, so it must be true, right? That facetious comment sums up late January’s proceedings in the stock market.

Space Xs and Os

Why anyone, Elon Musk or otherwise, would find this to be anything other than a way to discover and determine an accurate value for any business is curious to me. Here is his recent tweet that received plenty of attention.

Many people own their homes. However, many more often owe 80-90% or more of the value of it when they buy it. Realistically, they are closer to not owning it than owning it. Even if they “flipped” it at a profit, they did it with…wait for it…borrowed capital! The flipper earns the profit, but may have never paid in anything close to the cost of outright buying it.

Cars are leased, as well as owned. You get to drive it for a few years, but you don’t own it. You essentially borrow it from the dealer for that time. In fact, I Googled “Lease a Tesla TSLA .” “Only” 66 million results came up. How about that?

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It all started with the fact that for certain U.S. stocks, there was a very high level of “short interest.” That’s another way to say that those stocks were, in the eyes of some investors, much more likely to go down in price in the months ahead, instead of going up.

Dave Portnoy, Founder of Barstool Sports famously said last year that “stocks only go up.” He and I know that he was being as facetious as my comment above. But as in anything that has to do with money and competition, there are ultimately winners and losers.

Short selling is one way (but not the only way) for investors to attempt to profit from a stock’s price going down instead of up. Some hedge funds and other sophisticated, experienced investors may use shorting as part of their arsenal.

However, short selling is to investing what sword-swallowers are to entertainers: it is way, way at the high end of the riskiness spectrum. It is not something you just try to see how it goes. There are liquidity risks, risk of major loss (quickly), leverage and margin considerations.

That said, the mechanics of short selling are not as straightforward as buying a stock and selling it later. Let’s peel that onion back by a layer or two.

Early in my career, I was told this by a fellow investment professional about short selling: if you need a super-simple explanation of short selling, think of it as being the opposite of “long” investing. But that’s not what short selling is. To explain it, let’s quickly review what “long investing” is.

The long and short of it

Long investing is about as straightforward as it gets on Wall Street. It is when you buy a stock at $X per share, and aim to profit because its price rises to more than $X per share by the time you sell it. Back when I taught grade school children once a year at “Career Day,” we played a game called “Buy Low / Sell High.”

That’s what many people understand “investing in the stock market” to be. But there is more to it.

The stock market does not exist to make everyone’s dreams come true by buying stocks and holding them forever. That happens pretty often over time, but that’s not why companies “go public” and list their shares on stock exchanges.

Liquidity rules

A key reason the stock market exists and functions is because it provides LIQUIDITY to investors. You can’t buy a piece of a small business by just plunking money down. Same with a piece of real estate. There’s a transaction process, with steps and lawyers, and funding and such. It takes time.

The stock market cuts through all of that, and allows you to own shares of “public” companies by simply going to your financial advisor, computer or phone, and entering a buy order between 9:30AM and 4:00PM EST from Monday-Friday. That’s liquidity you can plan around. That’s the stock market.

But the market is also about measuring the value of the businesses that are listed on it. And, while most investors look for businesses (stocks) to buy that will go up in price, short sellers have a different way to pursue profits. They look for businesses that the market thinks too highly of. In other words, businesses that are, in their judgement, “overvalued.”

Inside the mind of the short seller

So, short sellers operate with this mindset: based on their analysis, they believe that a stock selling for $X a share is truly “worth” much less than that. If they are correct, they cannot profit from that by buying the stock. And if they do nothing about it, they miss an opportunity to capitalize on their research.

Instead they can sell the stock short. To do so, they borrow shares of stock from a broker, such that they owe that stock back to the broker eventually. When they do that, they receive the “proceeds” of that short sale at the time they shorted the stock.

If the stock price goes down, those same shares will be worth less than the short seller received. That allows them to repay those shares to the broker, but pay less to do so than they received when they shorted. This is called “covering the short sale.” As with selling a stock some time after you bought it, this completes the round-trip transaction, and the obligation of the investor. They sold Y number of shares short, they covered that short sale of Y shares, so their position is now, “flat.” That is, they own no shares of that stock and they are no longer short any shares of that stocks.

The opposite of buying? Yes and no.

If this sounds like the opposite of buying, then selling, it is similar. But the huge difference is the mechanics and the risk. When you buy a stock, the most you can lose is the amount of capital you invested. If you bought 100 shares of stock for $50 a share, you invested $5,000. If the company goes out of business, is deemed worthless and you are still holding those 100 shares, your investment will be worth zero. Not a great outcome, I know. However, you knew going in that $5,000 was your “worst-case scenario.”

When you borrow stock to initiate a short sale, the loss is not capped at all. If we take that same example, but instead of buying $5,000 of stock, you shorted 100 shares at $50 a share, your risk is technically unlimited. That’s because if the stock price goes from $50 to, say, $500 a share, you don’t own that stock…you OWE that stock back to the broker you borrowed it from. And, that little thing you borrowed for $5,000 is now worth $50,000 — not to you, but to the entity you owe it to! In other words, you are down $45,000 on a $5,000 investment. If this sounds like a really bad magic trick, its not. Its short selling.

WTF, WSB?

To put this in the context of recent stock market headlines, the hedge fund managers who shorted certain stocks did so because they believed these companies would eventually be worth much less than they were when they initiated their short sale trades.

Based on the murky outlook (at best!) for some of those companies, given the basic realities of the pandemic, the short selling hedge fund managers saw this as a way to profit from their research. The fact that it involved doing so by shorting instead of buying is like acknowledging that the team that scores fewer points during a game is the loser of the game. Except for golf, I guess!

So, it follows that as with other competitive endeavors, good performance, management and ultimate measured success is rewarded. And, poor decisions, bad luck or both are punished.

Assuming a position

Shorting is not a scam. Its an investment position, a posture, based on someone having a different opinion about a company’s stock than someone else. You know, the way some people prefer Cadillacs to other cars, even if they don’t necessarily want to own the stock of the maker of that car (for full disclosure, I don’t own a Cadillac or a Tesla).

You see, there is additional opportunity in the stock market for those who aim to not simply “invest for the long-term,” but instead use the stock market as a tool. A tool for what, you ask? For creating whatever type of return path you wish, and also setting some guardrails on the level of risk of major loss you are taking.

The stock market is just an inanimate object. However, that object is a very viable tool for pursuing whatever personalized investment objectives you have.

The “traditional” approach to investing is to buy a bunch of stocks, bonds and/or funds, hold them until you are older, and retire on that accumulated wealth. However, as I have educated and warned continuously in my articles, that approach has a much greater element of risk and hope and luck than most investors likely realize.

What happened in the recent case of Wall Street short sellers against an army of Main Street folks is perhaps the worst-case scenario for folks who try to profit by scouting out overvalued businesses. That’s because the army didn’t care about anything other than the fact that certain stocks were heavily shorted.

Some within that army did the research, good for them. But where it went out of whack is when so many others simply said with their money, “do what that guy is doing.” Is there something wrong with that? Not for me to say. That’s what regulators get paid to do.

There is so much more to say on this general topic of shorting, hedging, market emotions, speculating versus investing, and a lot more. For now, this hopefully delivered to you a primer on what this short selling thing is all about, and what different parties are thinking when crazy episodes like this occur. Since the events of January, 2021 will not soon be forgotten, it’s better you understand it than ignore it.

Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors.

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