If you’re going to be a short seller, here’s what you need to know

There has been a lot of press lately on outspoken short sellers who supposedly wreak havoc in the markets and on companies such as Valeant Pharmaceuticals International and, more recently, Home Capital Group Inc.

Short sellers themselves typically fit within one of two groups — those who remain behind the scenes and are secretive about their positions and those who are quite vocal about why they are short a company, in the hopes of driving the price lower by influencing others to sell the stock.

For those not familiar with the process, short selling involves an investor borrowing someone else’s stock while putting up a percentage of the position as margin and paying a pre-set amount of interest, including covering all dividends. The investor then proceeds to sell the stock in the market with the goal of buying it back at a lower price and returning it to the lender.

Since the stock is borrowed the returns are essentially leveraged, resulting in strong gains made when the stock sells off. However, the payoff profile is asymmetrical: The profit is limited from the time it is shorted down to $0, while the risk is unlimited meaning the share price has no cap on how high it can go. For example, let’s say you short 1,000 shares of a stock at $10. The maximum profit on the trade is if the share price goes to $0 and you make $10,000. If the share price rallies higher to let’s say $20, you are down $10,000 on the trade and will either have to put up margin to cover the new price or close out the position at a large loss. Since there are no limits as to how high it can go the maximum loss is unlimited, making it potentially a very dangerous trade for those who haven’t done their homework.

There is also a saying that markets often remain irrational longer than an investor can stay solvent, meaning an investor can be right with their trade thesis but wrong with the timing. Simply take a look at the monstrous rally in Home Capital’s share price before its recent collapse — those who were short the stock too early and either couldn’t stomach it or didn’t have the capital to cover the margin calls would have been hit with some large losses.

That said, there are a couple of ways to protect or limit the downside risks when shorting, but they are not without a cost. One method is to buy a put option on a stock instead of shorting it as the value of the put will increase as the share price falls. The benefit is that the downside is limited to the cost of the put but it also has an expiry date so an investor could make no money on the trade if the share price does not fall below the put’s strike price prior to expiry.

One could also de-risk an existing short position by purchasing an out-of-the-money call option which will limit the downside risk to the level of the call’s strike price. In the aforementioned example, an investor could by a call option with a $15 strike thereby putting a floor on the trade with a maximum loss of $5,000 (plus the cost of the call) against a maximum gain of $10,000 (less the cost of the call).

While many in the industry dislike short sellers as they profit on the losses of others, we do think they play a role in improving market efficiencies by devaluing or even eventually removing those poorly run companies from the public markets.

Short sellers can also provide great opportunities when they’re wrong, which can lead to a “short squeeze” in which they must cover or buy-back their short positions, thereby sending the stock rebounding much higher.

Either way, it helps to understand the process and that those who are short often have a very good reason for doing so given the amount of risk they are taking on. It is therefore up to you as an investor to determine if they are right or wrong. Martin Pelletier, CFA , is a portfolio manager and OCIO at Trivest Wealth Counsel Ltd.