The long and the short of it

Arthur Smelyansky has been an avid retail investor since the day he turned 18.

“My economics teacher was trading and making more money in the lunch hour than he was during the week teaching us,” he says. “And I couldn’t wait to join him in those ranks.”

Now 35, Smelyansky has taken specialized courses through the Canadian Securities Institute and has done a bit of short selling. But he has advice for those thinking about getting into it.

“It’s riskier than you think.” Short selling involves borrowing a stock or other security through a broker. The borrowed security is then sold quickly, repurchased after a time, and eventually returned to the lender.

In essence, the short seller operates on the premise that the security’s price will fall enough to cover costs and make a profit before it must be repurchased and returned.

For example, somebody who “sold short” Home Capital shares at $17.71 on April 20 could have replaced them with shares bought a week later at $8.02, resulting in a return of 120 per cent, before fees. But that’s an exceedingly rare scenario.

Critics of short selling point out there’s a limit to how much profit can be made since a security’s price cannot go below zero, but there’s theoretically no limit to potential losses if the market price goes up instead of down.

Marshall Beyer, who is in charge of curriculum at the Canadian Securities Institute, said short selling isn’t suitable for most retail investors but argues they should be aware that any given stock could be a target for short sellers.

“It’s a market factor — just like other factors that may impact the price of a stock,” Beyer says.

Wuyang Zhao, an assistant professor at University of Texas at Austin, says his PhD research demonstrated that “activist” short sellers have a disproportionate impact on the market because of their public pronouncements.

“You should pay attention to active short selling campaigns,” Zhao says, adding that investors should do their own research about the stock’s fundamentals and not blindly follow short seller claims.

He notes the unusual case of Element Fleet Management Corp., a Toronto-based financial services company, that saw its stock plunge 39 per cent on May 31 after Muddy Waters Research announced it had found a new Canadian target.

The same day, Muddy Waters - the same firm that exposed shortcomings at Sino-Forest Corp. - clarified that Element wasn’t the target and its shares began to claw their way back up.

“In that case, we can clearly separate information from panic,” Zhao says.

Colin Talpos, a retail investor who made the transition to professional day trader about three years ago, says he doesn’t have a bias for or against short trading.

“I look at the market and if things are looking bad, I’ll short. If things are looking good, I’ll be long,” Talpos says. “If you’re going to be an active market participant, you should know that markets aren’t always going to go up.”